Drobny, The Invisible Hands

In his preface to the new edition of The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money (Wiley, 2014) Steven Drobny contends that “real money investors remain stuck in their antiquated ways. They will view their investments from a notional allocation standpoint, and diversify their holdings by asset class names, not by underlying risk characteristics.” Investors are unprepared for another crisis, despite the fact that “quantitative easing is coming to an end, and tremendous uncertainty exists everywhere.” Hence the renewed timeliness of the interviews, conducted in the spring of 2009, with traders who managed to navigate the financial crisis of 2008.

With the exception of Jim Leitner, who was also interviewed for Drobny’s Inside the House of Money, the managers—ten who run global macro hedge funds and one real money manager—remain anonymous. Drobny “chose the anonymous route to increase candor as well as keep the focus on the ideas as opposed to the personalities.” (p. xxx)

The Invisible Hands is a terrific book even though many of the strategies described in it are difficult if not impossible for the individual investor to implement. But the thinking behind these strategies and the way their risk is managed are often so compelling that everyone who is active in the markets can learn a tremendous amount from the interviews. Moreover, even though most of the contributors are anonymous their life stories are fascinating, sometimes even inspiring.

Here are just three snippets. They are not representative of the book as a whole because it doesn’t lend itself to such piecemeal extraction.

“The Philosopher” finds opportunities in our flawed attempts to understand an uncertain economic future. “The human brain,” he notes, “is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.” (pp. 98-99)

“The Predator” always wants to know what kinds of people are on the other side of his trades. “You need buyers to short against at the top of the market and sellers to buy from at the bottom. You have to identify the type of person who shorts at the bottom or the one who leverages on the way up and use the liquidity they provide to do your trades. You need to understand where other people get it wrong in order to see if their errors create an opportunity for you.” (p. 315)

And, finally, “The Plasticine Macro Trader” opines that “even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following.” (p. 344)

Bhansali, Tail Risk Hedging

Vineer Bhansali’s Tail Risk Hedging: Creating Robust Portfolios for Volatile Markets (McGraw-Hill, 2014) is a book that unfortunately will never reach a mass audience. I say “unfortunately” because by and large investors are horrible risk managers. Most have long-only portfolios; the savvier among them pride themselves on being diversified. But in a major sell-off, where correlations usually increase dramatically, they are unprotected and will most likely end up bloodied.

Bhansali argues that “typical investment portfolios … suffer from too much asset-class diversification and not enough risk diversification.” (p. 184) The problem is that “even assets that are fundamentally uncorrelated may become correlated on the tails if they are affected by a common liquidity factor.” (p. 18) This problem, however, can be converted into an opportunity. “For example, if we believe that there are concentrated carry positions in some currency pairs that will come under liquidation pressure if the equity or credit markets come under pressure, then a carry currency put option bought in advance of the stress would prove to be a cheap way of hedging.” (p. 19)

Bhansali emphasizes that “the use of market-traded options is a simplification that works only if the underlying hedge objective is rather plain vanilla. If the objective is more complex, for example, ‘hedge so that at no point in time does the portfolio suffer a loss of more than x percent,’ the reference index security would have to be more of an exotic option such as a knock-in option.” (p. 41)

Options are not the only way to hedge tail risk. “We should use cash, diversification, alternatives, and explicit hedging within a consistent cost-benefit tradeoff to construct the most efficient and practical solutions.” (p. 43)

Bhansali explores the advantages of static hedges versus dynamic hedges. “In static hedging, the buyer of protection buys a contractual obligation that if a particular event were to happen, the seller of the protection would pay according to a predefined formula. By contrast, in dynamic hedging, the protection seeker uses some algorithm to create the payoff he would have as if he had actually purchased the static hedge but without actually paying for the hedge now. In other words, static hedging is outsourcing of risk management to the options, whereas dynamic hedging is doing option replication in-house. In practical terms, static hedging consists of buying options, for example, S&P500 put options or indirect options, whereas dynamic hedging is done by replicating the option using the underlying instruments, for example, by selling and buying S&P500 futures.” (pp. 146-47) Bhansali suggests that the investor should “pay as you go for small losses using rebalancing and dynamic hedging, but … combine this strategy with sufficient static hedges on the tails to avoid the possibility of permanent losses from the rare but severe fat tails.” (p. 152)

When trying to hedge tail risk for retirement accounts, the investor is confronted with “the interplay among risk aversion, horizon, and the dynamics of markets over long periods of time.” The author says that everything he has written about tail hedging for asset allocation “still holds true, such as the need for active management, its role as an offensive risk-management tool, and its role in mitigating downside risks. However, the introduction of time to retirement and risk tolerance as new variables makes the exercise even more complex and fruitful.” (p. 186)

Although Bhansali oversees PIMCO’s quantitative investment portfolios, he introduces relatively little math in this book. The reader should, however, be familiar with options and the basic metrics of risk management.

Drobny, Inside the House of Money

If you haven’t read Steven Drobny’s Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets, newly revised and updated (Wiley, 2014) you should immediately add it to your “to do” list. It doesn’t matter whether you’re a global macro trader or not. I’m not, and yet it’s one of the very few books I keep returning to and learning from.

Originally published in 2006, the book is a collection of twelve interviews with top global macro practitioners. Although times have changed—the interviews were conducted before the financial meltdown and since then global macro has gone mainstream—the book remains a font of trading wisdom.

Few of the interviewees are household names; notable exceptions are Jim Rogers and Peter Thiel, and Thiel has since closed down his fund. The other named traders (one is anonymous) are Jim Leitner, Christian Siva-Jothy, John Porter, Sushil Wadhwani, Yra Harris, Dwight Anderson, Scott Bessent, Marko Dimitrijevic, and David Gorton and Rob Standing.

It’s, of course, impossible to summarize this book, which is one reason it’s so valuable. But, just to give a bit of its flavor, here are a couple of excerpts.

First, from Scott Bessent, at the time of the interview running his own fund but now the chief investment officer of Soros Fund Management. He said that his fund uses technical analysis as a way to see what the crowd is thinking. “And we also use it to keep us on top of things we might not be seeing. We have a system that screens about 1,400 stocks and commodities around the world every week. We never trade based on it, but if all of a sudden 10 stocks in Indonesia show up, then we’ll look at Indonesia.” In response to a question about the source of his information, he said: “A lot of newsletters, thought pieces, magazines. We get very few ideas talking. We basically just sit around here and read.” (p. 271)

Second, from the thought provoking interview with Jim Leitner of Falcon Management. His fund—at least at the time of the interview—allocated 10 percent of its NAV to a baseline portfolio, which dynamically adjusts the weights on how much money it holds in equities, fixed income, commodities, currencies, and real estate, based on a momentum following model. It is a model “with no forecasting, no thinking, and no work to implement. We rebalance the model book every Thursday and do not do anything in between.” The fund’s overall performance the previous year was 29% as opposed to the 14% return of the baseline model, but, Leitner said, “the baseline model keeps me sharp. I know that there is always someone out there who is trying to each my lunch.” (p. 77)

Crouhy, Galai, & Mark, The Essentials of Risk Management, 2d ed.

In this second edition of their critically acclaimed The Essentials of Risk Management (McGraw-Hill, 2014) authors Michel Crouhy, Dan Galai, and Robert Mark update their work to reflect lessons learned from the financial crisis. The authors focus on the banking industry, but they consider issues in nonfinancial corporate risk management as well.

The book, which runs some 650 pages long, is a veritable encyclopedia. Its seventeen chapters cover such topics as banks and their regulators, corporate governance and risk management, theory of risk and return, interest rate risk and hedging with derivative instruments, measuring market risk, asset/liability management, credit scoring and retail credit risk management, commercial credit risk, quantitative approaches to credit portfolio risk and credit modeling, the credit transfer markets, counterparty credit risk, operational risk, model risk, stress testing and scenario analysis, and risk capital attribution and risk-adjusted performance measurement.

As the chapter titles indicate, it is not light reading. The book is probably best viewed as either a textbook or a reference book.

Borman, Forex DeMYSTiFieD

The DeMYSTiFieD series prides itself on making hard stuff easy. David Borman’s Forex DeMYSTiFieD (McGraw-Hill, 2014) goes a step further; as the cover says, it offers the reader the opportunity to “master key forex trading principles painlessly.” Who doesn’t like easy and painless learning? I’m not poking fun at this series. I myself have been known to turn to books in the series for a quick introduction to subjects about which I was woefully ignorant. And I always got at least “a little learning.”

David Borman’s book on Forex covers the basics pretty well. The problem is that it often makes profitable Forex trading seem like, to mix metaphors, a joy ride and a slam dunk. Although the book deals extensively with risk management (sometimes a bit idiosyncratically), it also has an element of hype. Here are a couple of examples. “Traders can make a profit on as little as $250 USD. Even $100 can still reward you with gains and the thrill of participating in a worldwide market.” (p. 68) “Change how you play the market game to fit your rules in day trading. Reduce the risk, raise your enjoyment level, and you may find yourself truly enjoying a new hobby of day trading.” (p. 70) Or referring to times when markets are expected to be subject to wild swings, “Uncertain times like these also give you the opportunity to take some of your profits out of your account and spend them on a much-needed vacation or other enjoyable activity.” (p. 32)

As for risk management, Borman recommends pyramiding. “The best procedure is to know ahead of time the dollar amount you would like to commit to the trade, and then divide by five. This new dollar amount should be the most you spend on that trade. … With this one-fifth entry amount, you will have adequate cash in your margin account to buy-in more when the price moves against you (which it will, no doubt!). Keep buying in as the price gets lower, and even as the price gets higher and your trade gets into the profit point. … To fully round out the idea of Forex pyramiding, sell off the position in the same manner in which it was bought. … The net effect of getting into and out of trades with the pyramiding method can go a long way, acting as a risk management technique that is very easy to manage, control, and execute. A good Forex pyramiding technique will, on average, work to keep the most profits in your account while keeping losses to a minimum.” (pp. 52-53) Except, of course, when currencies trend against you.

Forex traders with some experience can pick and choose their way through this book and undoubtedly come up with a few nuggets. Beginning traders beware.

Morris, Investing with the Trend

Gregory L. Morris has been a technical market analyst for over forty years, which means he’s pretty much seen every kind of market—bull and bear, choppy and meandering, bubbles and crashes. He’s also seen the ups and downs of technical analysis’s reputation: it “used to be greeted with as much enthusiasm as Jeffrey Skilling addressing the Better Business Bureau.” (p. 399)

Investing with the Trend: A Rules-Based Approach to Money Management (Bloomberg/Wiley, 2014) is technical analysis at its finest. It is thoughtful and chock full of data and charts that support Morris’s overarching, well-developed theses that (1) markets trend much more than not and (2) risk is drawdown.

Morris challenges many tenets of conventional financial wisdom and practice, delivering well-placed punches, often with an element of humor. He starts with some flawed assumptions, such as that the markets are efficient, investors are rational, returns are random and normally distributed, alpha and beta are independent of correlation, and volatility is risk. And even though (and perhaps because) his own formal education was in aerospace engineering, he decries the insane overuse of advanced mathematics, “usually in the form of partial differential equations,” in financial papers, “more often than not just to hide an intellectual void.” (pp. 65-66)

He offers up some compelling images. For example, he writes: “When the market starts to decline significantly it is not the same as when someone yells ‘fire’ in a theater. In a theater everyone is running for the exits. In a big decline in the market, you can run for the exits, but first you have to find someone to replace you—you must find a buyer. Big difference!” (p. 138)

For Morris, technical analysis is “much more art than science; the science part is more related to the process of research than the actual analysis.”(p. 148) He is no fan of Fibonacci numbers, which he considers so much numerology. “As far as Elliott Wave theory goes, there are often so many complications and conditions introduced into using this type of analysis, that it is incapable of being proved wrong. Sometimes I think it gets adjusted more often than earnings estimates.” (p. 150) Seasonality doesn’t fare much better. He suggests that “seasonality is a perfect example of observable information; you just can’t make a trading decision based on it. … [I]nvesting decisions based solely on statistical evidence are unsound.” (pp. 156-57)

What Morris offers the technically inclined investor is research using a simple process of filtered waves and time to determine market trend, guidelines for selecting securities to buy, and a way to measure market risk. He spells all this out in great detail, with supporting evidence. He does not offer the system. Instead, he provides guidelines on how to set parameters that best meet an individual’s goals. The investor who follows a good system will have a major advantage over most folks who are invested in the market. As Morris writes, “a rules-based model along with the discipline to follow it will help remove the human subjectivity and those horrible human emotions that we all have.” (p. 399)

Morris’s own list of ten investing rules starts with an admonition to turn off the TV. He continues: “Develop a simple process, one that you can explain to anyone…. Create a security selection process based on momentum. Devise a simple set of prudent and reasonable rules and guidelines. Follow your process with discipline; without it, you will fail.” (p. 403)

Sounds deceptively easy and perhaps a bit vague, but Investing with the Trend is neither. It’s a first-rate account of how to develop a custom-fit trading model.

Pignataro, Leveraged Buyouts

Paul Pignataro, the founder and CEO of the New York School of Finance, recently wrote Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity. He has now followed that work up with another “practical guide to investment banking and private equity”: Leveraged Buyouts (Wiley, 2014). Earlier he used Walmart as his case study. This book is a detailed case study of the Berkshire Hathaway/3G Capital $28 billion buyout of Heinz.

Pignataro’s step-by-step approach is ideal for anyone trying to learn or hone the analytical skills necessary to model the basic viability of an LBO, from the point of view of the company as well as the investor. He explains valuational concepts and how to capture them in Excel spreadsheets, the latter described down to the level of individual keystrokes.

A full-scale LBO model will include the assumptions underlying the proposed purchase, the company’s income statement, cash flow statement, balance sheet, balance sheet adjustments, depreciation schedule, working capital, balance sheet projections, debt schedule, and projected LBO returns.

Pignataro also takes the reader through advanced leveraged buyout techniques such as accelerated depreciation, preferred securities and dividends, debt covenant ratios and debt fee amortization, and paid-in-kind securities.

The book has a companion website which contains models on Heinz for download, chapter questions and answers, and a second practice LBO model.

All in all, Leveraged Buyouts is a self-contained course in rudimentary financial modeling (and a crash course in Excel as well). It’s a perfect read for anyone wanting to enter the world of investment banking or private equity.