Travers, Hedge Fund Analysis

Investors who are thinking about handing over a portion of their assets to a hedge fund manager are often at a loss about where to turn. Some of the legendary funds have either closed or are not accepting new outside money. A lot of funds are underperforming duds. A few are frauds. New funds that often outperform are unknown quantities. What is an individual investor (admittedly, one with a fair amount of time on his hands) or a professional responsible for allocating institutional money to do? For starters, he can read Frank J. Travers’s Hedge Fund Analysis: An In-Depth Guide to Evaluating Return Potential and Assessing Risks (Wiley, 2012) and learn how to become his own due diligence analyst.

The first step is to troll through hedge fund databases, some available at no cost, screening for potential candidates. Let’s say you want an equity long/short fund in the U.S. with a minimum three-year track record, annualized return in the top quartile of its peers, minimum assets under management of $250 million, and reasonable liquidity terms. You can narrow the field substantially with just these parameters. Making some qualitative judgments here and there, let’s assume that you manage to whittle the funds down to just five for further review. Your real work is about to begin as you evaluate which fund is the best fit with your total portfolio of investments.

Travers chooses one of these funds, which he dubs Fictional Capital Management, as his case study. He analyzes it from start to finish, including mock interviews with key investment personnel and an operational review. The analysis is exhaustive.

In fact, the book is so detailed that I’m sure even the least astute analyst could successfully use it as a complete cheat sheet (or, the less tainted word, template) in performing his own due diligence. Travers has performed a real service for anyone who is trying to find the right hedge fund to add to his portfolio.

Nahin, The Logician and the Engineer

Back when I took high school physics, a course taught by a thoroughly uninspired and uninspiring man whose name I have mercifully forgotten, a group of guys (who I suspect went on to become TV repairmen) and I had a pact. I would do their math homework and they would do my “hands-on” projects, especially those involving electrical circuitry. Left to my own devices I would undoubtedly have sent sparks flying in all directions.

Fast forward. Here I am with Paul J. Nahin’s book The Logician and the Engineer: How George Boole and Claude Shannon Created the Information Age (Princeton University Press, 2012). The author promises that no knowledge of electronics is required, just an understanding of polarity, Ohm’s law for resistors, and the circuit laws of Kirchhoff. “No more than a technically minded college-prep high school junior or senior would have.” Well, that stirred up a lot of bad memories.

So, rather than pretend that I relish looking at wiring diagrams I decided on a different tack. Motivated by a book I recently finished but cannot review for a while (Mastery), I thought it might be worthwhile to look at how Boole and Shannon, men from different centuries and very different backgrounds, came to be such remarkable thinkers.

In today’s post I’m not drawing any conclusions, just presenting short biographies.

George Boole was born in Lincoln, England, in 1815. His father was a cobbler who “seems to have been able to do anything well except his own business of managing the shop.” His real interests lay in mathematics and the construction of optical instruments, interests that he shared with George.

Boole’s formal education was scanty—after primary school a brief stint at a commercial school. He taught himself languages in preparation for becoming a clergyman. But fortunately for the world he soon enough found his true calling. At the age of sixteen he became an assistant teacher of Latin and mathematics at a small boarding school, a job he lost after two years. Among his many sins, he did math problems in chapel. In the evenings, “after a day of being a bad teacher to dull boys,” he plowed through a book on differential calculus which prepared him to read the classics of Lagrange, Laplace, Newton, and Poisson. “As Boole later explained to a friend, he managed it all by sheer force of will, just reading and re-reading, over and over, until he understood.” (p. 20)

Boole continued to teach at various day and boarding schools, all the while writing math papers, inspired perhaps by the establishment of a new math journal, the Cambridge Mathematical Journal. The editor of the journal, Duncan F. Gregory, gave Boole “almost incredibly generous aid,” without which “it is not unreasonable to imagine that Boole’s spirit would have been crushed right at the start.” Gregory published Boole’s early papers and then, when one was too elaborate for the Journal, recommended that Boole submit it to the Transactions of the Royal Society of London. This paper earned Boole a Royal Medal as the best mathematics paper published in the Transactions in the previous three years.

At the age of 34, with no university degree, Boole was appointed professor of mathematics at Queen’s College (today’s University College), Cork, Ireland, where he spent the rest of his short life. He continued to publish and moved “from one honor and achievement to the next.” (p. 27) He died, presumably from pneumonia, shy of his fiftieth birthday.


Claude Shannon was born in Michigan in 1916. His father was a business man and probate judge; his mother, a language teacher and high school principal. Early on Shannon displayed an interest in how things work; when he was in high school he earned pocket money by fixing radios at a local department store. He graduated from the University of Michigan with degrees in mathematics and electrical engineering and then, as a graduate student, got a job as a research assistant in MIT’s Department of Electrical Engineering to work part-time on Vannevar Bush’s differential analyzer, the world’s most advanced analog computer.

In Bush Shannon found “an early mentor” (and champion) “every bit as important to him as Gregory had been to Boole.” (p. 29) Shannon’s job involved understanding and maintaining the analyzer’s controller, a complex circuit of over 100 relays. It wasn’t long before Shannon had his epiphany of marrying Boolean algebra with electrical switching circuits. He described his work in his MIT master’s thesis, labeled by many “the most important master’s thesis ever written.”

After a foray into genetics (and eugenics) for his Ph.D., Shannon eventually ended up at Bell Labs for “an astonishingly creative fifteen years,” doing some work early on in cryptography, and in 1948 publishing “the Magna Carta of the information age,” his “Mathematical Theory of Communication.”

Shannon was strange man. Not only did he ride a unicycle through the corridors of Bell Labs while juggling balls, but he created all manner of toylike gadgetry. Some of the gadgets were scientifically intriguing, others pointless. Perhaps the weirdest was Shannon’s “Ultimate Machine.” Arthur C. Clarke described it thus: “It sits on Claude Shannon’s desk driving people mad. Nothing could look simpler. It is merely a small wooden casket the size and shape of a cigar box, with a single switch on one face. When you throw the switch, there is an angry, purposeful buzzing. The lid slowly rises, and from beneath it emerges a hand. The hand reaches down, turns the switch off, and retreats into the box. With the finality of a closing coffin, the lid snaps shut, the buzzing ceases, and peace reigns once more. The psychological effect, if you do not know what to expect, is devastating. There is something unspeakably sinister about a machine that does nothing—absolutely nothing—except switch itself off.” (pp. 35-36)

In 1958 Shannon left Bell Labs to go back to MIT. There he became interested in portfolio theory and, as William Poundstone described in Fortune’s Formula, became wealthy by applying his ideas to his personal finances.

Unfortunately Shannon was eventually afflicted with Alzheimer’s disease and spent the last seven years of his life in a nursing home.

Wachtel, The Sensible Guide to Forex

HSBC recently released a report announcing a new era for FX where, as a result of central bank intervention and low interest rates, currency trading has become much more volatile and harder for investors to interpret. “The demise of carry has brought ‘onion skin’ layers of uncertainty into the FX market, tears and all.”

Enter Cliff Wachtel’s The Sensible Guide to Forex: Safer, Smarter Ways to Survive and Prosper from the Start (Wiley, 2012). It is a beginner’s book, written for those who never participated in the glory days of carry when “the FX market had the luxury of a clear framework for understanding and trading currencies, “ a time when, if you got your interest rate calls right, you were basically home free.

Wachtel offers a different kind of framework, one centered on trader psychology and what the author calls RAMM (risk and money management). He complements these key elements with technical analysis and a smattering of fundamental analysis. Although this framework is certainly not unique to forex, Wachtel explains at length how it can help an investor identify, execute, and manage simple, low-risk, high-yield, longer-term FX trades.

The first half of the book deals with the basics; the second half with trade examples, momentum and timing indicators, intermarket analysis, and “newer, smarter” methods. If you’re one of those impatient souls who peeks at the last pages of a mystery before you’re even familiar with the characters, I’m sure you’ll want to know up front what the newer, smarter methods are. I’ll accommodate, but only with a single sentence. “For those seeking simpler ways to tap the potentially faster profits from short- to medium-term (ranging from minutes to weeks) trading of forex, with more controlled risk, we introduce two new and very useful instruments: forex social trading [and] forex binary options.” (p. 295)

Wachtel breaks little new ground in this book, but he offers a solid, far-reaching course in trading. Beginners will learn a great deal (even though, if they have little experience in the markets, they will have to stretch to grasp everything). For those who have yet to trade profitably the book may serve as a useful refresher course. Even investors who think that “trading” is a four-letter word will discover how to use currencies to diversify their portfolios and to ride long-term forex trends for lower risk, higher income.

Let’s expand our horizons

A host of publishers have banded together to lend digital galleys of forthcoming books to qualified reviewers. I have already taken advantage of this service to bring you reviews of the following titles: Who Stole the American Dream?, The Power of Habit, Makers, and Practice Perfect. Among the coming attractions are The Logician and the Engineer (How George Boole and Claude Shannon Created the Information Age), Mastery, and The Secret Financial Life of Food. I don’t review a book before its official publication date, so not all of the coming attractions are imminent.

This venture is a win-win for both publishers and readers. Since publishers don’t have to ship hard copies, they are more generous with their new releases. It gives them greater exposure for presumably much less money. And it means I can review books I think would (or should) be interesting to traders and investors even though few have financial keywords in their titles.

Naturally, it’s more work for me since I will also keep up my reviews of financial titles, but I like expanding my horizons and I trust you do as well. I promise no Harlequin romances.

Singer, Trade the Congressional Effect

Congress, Eric T. Singer argues, is bad for your portfolio’s health. And he’s not referring to just the current dysfunctional Congress. “[C]ongressional dysfunction is the norm and … is likely to be permanent.” (p. 58)

In an article he wrote for Barron’s in 1992 Singer introduced the notion of the Congressional effect—that equities earn less when Congress is in session than when it is not. Trade the Congressional Effect: How to Profit from Congress’s Impact on the Stock Market (Wiley, 2012) updates and elaborates on this notion. For starters, and most compellingly, “from 1965 through 2011, measuring each of the 11,832 trading days during that period, the price of the Standard & Poor’s (S&P) 500 Index rose at an annualized rate of less than 1 percent on days Congress was in session, but over 16 percent on days they were out of session.” (p. 13) Moreover, “the Congressional Effect is growing as government grows and investors become more wary about its impact on the market.” (p. 39)

Singer, who is on the right on the political spectrum, subscribes to Thomas Paine’s advice that “that government is best that governs least.” As a result, he sometimes ascribes to Congress more damaging power than it probably has. For instance, he argues that “the proximate cause of the Crash of 1987 was the inexplicably casual trial balloon of eliminating interest deductions for junk bonds if they were used for acquisitions.” (p. 38) Well, perhaps, and I certainly can’t take the other side of the argument, but on the surface the claim seems a bit exaggerated.

Congressmen are, in the words of one of their own, “issues entrepreneurs.” They look for issues they can use as leverage to gain campaign dollars and voter support. And at least until the passage of the Stop Trading on Congressional Knowledge Act (the STOCK Act) this past March, they were also remarkably good investors, consistently beating the market in a way that only people trading on inside information can. Moreover, “public servants enter Congress from all walks of life, but they almost all emerge rich, and the implication is that they all used their influence to feather their nests." (p. 55)

Congressmen become rich even as their constituents’ equity portfolios languish. So how can you dodge Congress’s bullets? One obvious way is to hold some S&P 500 analog on the days when Congress is out of session and be in cash otherwise. Singer manages the Congressional Effect Fund, which has slightly underperformed the S&P 500 since its inception in 2008 but with much less volatility.

Otherwise, investors can look to value funds, international markets, and gold to help preserve their wealth. Active investors can track proposed regulatory legislation since it “usually has unintended consequences that adversely affect that industry and the sectors of the economy that industry serves.” (p. 110)

Among the highlights of this book are data on the election cycle and lame duck sessions as well as an analysis of Congress’s approach to behavioral finance.

Trading the Congressional Effect is a timely, provocative book. It also illustrates how difficult it is to capitalize on a clearly defined trading edge.

Lemov, Practice Perfect

Although the authors of Practice Perfect: 42 Rules for Getting Better at Getting Better (Jossey-Bass/Wiley, 2012)-- Doug Lemov, Erica Woolway, and Katie Yezzi—are teachers and focus on how to coach teachers to do a better job, the book has lessons for everyone who wants to coach himself to improve his game.

By now I assume nearly everybody has heard about the 10,000 hour rule, detailed among other places in Malcolm Gladwell’s Outliers. That is, it takes 10,000 hours of practice to become an expert. But what kind of practice? To borrow (and recast) a 2008 Republican campaign slogan, “Drill, baby, drill!” Practice should focus on drills rather than on scrimmages. “A drill deliberately distorts the setting in which participants will ultimately perform in order to focus on a specific skill under maximum concentration and to refine that skill intentionally. Drills … increase density, the number of productive iterations of a skill per minute of practice. … A scrimmage, by contrast, is designed not to distort the game but to replicate its complexity and uncertainty.” (pp. 49-50) Scrimmages should be used to evaluate one’s readiness for performance: “success in scrimmage is the best indicator of true mastery—participants can perform a skill when the time and place of its application is unpredictable.” (p. 51)

Okay, we should drill. The trader could, for instance, practice the physical act of trade entry (and drill in a variety of conditions—entering via a limit order or a buy stop, reacting to a partial fill, canceling a trade) until he can do it quickly and virtually automatically, preferably without a fat finger. It makes no sense to spend an inordinate amount of time figuring out entry rules only to stumble when actually placing the trade. Even algo traders need to know how to override their systems manually.

It is important to practice getting simple things right before adding complexity; that is, we want to encode success. As the authors write, “failure builds character better than it builds skills.” (p. 251) And we should spend most of our time on the skills that matter most—the old 80-20 rule (spend 80% of your time practicing the 20% of skills that are most important).

The best performers continue to drill even after they have attained mastery: “the value of practice begins at mastery!” (p. 32) “Keep going so that what you develop is automaticity, fluidity, and even … creativity.” (p. 30)

Through practice people develop “’economical rote algorithms’ so that ‘in the heat of battle the right maneuvers will come automatically.’ Consider hitting a baseball. It takes about 0.4 seconds for a serious fastball to reach the plate. ‘Conscious awareness takes longer than that: about half a second,’ … so most batters are not consciously aware of the ball’s flight. … Success is based on habits the batter has built but cannot consciously manage in the moment when they are most needed.” (p. 34) Sounds a lot like Curtis Faith’s Trading from Your Gut, which I reviewed almost three years ago.

Since it is geared to teachers, Practice Perfect is not essential reading for traders, but it contains some key lessons—among them, stop scrimmaging so much and start drilling.

Book sale

Once again, I’m offering readers of this blog an opportunity to get books that I’ve reviewed at cut-rate prices.

Here’s the deal. I will sell the books on the first list for half the current official Amazon U.S. price plus the cost of domestic media mail—figure between $3 and $3.50 for a single title, less per book for multiple titles. (I’m willing to ship outside the U.S., but shipping charges can be prohibitive.) Books on the second list I’ll part with for a third of the Amazon price. If outside sellers on Amazon are offering new copies for less than that price, I’ll match them. Orders that total over $100, excluding shipping, will be eligible for an additional 10% discount.

As I’ve written many times before, the books are officially used because, yes, I read them. But I have one of the tiniest “book footprints” on the planet; my used books look better than most new books at the local bookstore. No dog ears, no coffee—or, in my case, tea—stains, no visible fingerprints.

In deference to the publishers who so kindly supply me with review copies, I am not offering anything I have reviewed in the last three months.

If you would like to buy any of these books, please email me at readingthemarkets@gmail.com. My preferred method of payment is PayPal. I’ll fill “orders” on a first come, first served basis and I’ll update the list as I receive payment.

So, here goes with

LIST ONE:

Anson et al., The Handbook of Traditional and Alternative Investment  Vehicles
Bernstein, The Power of Gold (paper)
Byers, Blind Spot (stamped “review copy not for resale” on bottom    edge)
Caliskan, Market Threads (stamped “review copy not for resale” on  bottom edge)
Doty, Bloomberg Visual Guide to Municipal Bonds
Esperti et al., Protect and Enhance Your Estate, 3rd ed. (paper)
Fogarty & Lamb, Investing in the Renewable Power Market
Frush, The Strategic ETF Investor
Klein, Dalko, and Wang, Regulating Competition in Stock Markets
Kolb, Financial Contagion
Malz, Financial Risk Management
Phillipson, Adam Smith
Rahemtulla, Where in the World Should I Invest?
Schneeweis et al., The New Science of Asset Allocation
Sklarew, Techniques of a Professional Commodity Chart Analyst
Standard and Poor’s 500 Guide, 2012 ed. (paper)
Stoken, Survival of the Fittest for Investors
Toma, The Risk of Trading
Wagner, Trading ETFs, 2d ed.
Weiss, The Big Win


LIST TWO:

Au, A Modern Approach to Graham & Dodd Investing
Ayache, The Blank Swan
Bhuyan, Reverse Mortgages and Linked Securities
Biggs, A Hedge Fund Tale of Reach and Grasp
Diacu, Mega Disasters (stamped “review copy not for resale” on top  edge)
Dobson & Reimer, Understanding Spreads (paper)
Fraser, Wall Street: America’s Dream Palace (paper)
Harstad, Live It Up! But Don’t Outlive Your Income (paper)
Isbitts, The Flexible Investing Playbook
Levinson & Horowitz, Guerrilla Marketing Goes Green (paper)
Sorkin, Too Big to Fail
Standard & Poor’s 500 Guide, 2011 ed. (paper)
Triana, The Number That Killed Us
Wasendorf, The Secret Keys to Smart Investing (paper)