Thursday, July 16, 2009

Drobny, Inside the House of Money

Inside the House of Money by Steven Drobny (Wiley, 2006) is a collection of thirteen interviews with key players in global macro hedge funds. They focus on fundamentals (often very loosely defined) and are primarily discretionary traders. In addition, they are “scary smart.” To my mind Drobny’s book is one of those rare gems that merits frequent re-reading, quite independently of what or how one trades. Here I’ll mention only a couple of takeaways.

First, two insights from Jim Leitner of Falcon Management who trades options wherever possible in his fund (mostly his own money) because “it’s like paying for someone else to be your risk manager.” He contrasts how real money accounts such as the Yale Endowment Fund and hedge funds view risk management. The smart real money accounts use diversification and rebalancing as their primary risk management tools. That is, they determine their initial allocation mix and as markets rise and fall they rebalance. In so doing, they actually increase risk; they sell a portion of their winning instruments and buy more of the losing instruments. Hedge funds, by contrast, simply cut risk at some point.

Leitner tries to earn risk premia and considers currencies an obvious place to look. After outlining three possible strategies, he turns to the fact that in foreign exchange “daily volatilities are much higher than the information received.” He uses the euro as an example: in July 2001 it bottomed out at 0.83 to the dollar and by January 2004 was trading at 1.28. Dividing the 45 “big figure” by 900 days gives an average daily move of 5 pips. Now if the one-month volatility averaged around 10% during that time, the daily expected range would be 75 pips—a signal-to-noise ratio of 1 to 15. “Noise is just noise, and it’s clearly mean reverting. Knowing that, we should be trading mean reverting strategies.”

Peter Thiel, former CEO of PayPal, runs Clarium Capital Management. Arguing that markets have become highly correlated and that broad diversification is neither practicable nor desirable, he turns to the question of risk management. His hedge fund assumes that all their positions correlate perfectly and that the maximum loss they are willing to take in a disaster scenario is 15 to 20 percent. They size their portfolio accordingly and place stop losses (not trailing stops) on each trade. They also look to non-price (e.g., volatility and sentiment) indicators to assess the strength of their trades as they progress. “When price is used as the only indicator, things devolve into an ineffective charting exercise.”

Drobny’s book is replete with challenges to the way most retail investors and traders look at markets. As such, it’s a real keeper.

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