Monday, July 14, 2008 and poker

I got into an interesting discussion last week as to whether the market is actually beatable by retail investors (or hedge funds and mutual funds for that matter) in the long term. The basic idea that my friend was trying to push through was that it is NOT BEATABLE. Majority of funds and even a bigger majority of the retail investors are either market trailing or will probably return at best the index's performance. He describes it as being a game of chance and those that are making money just happen to be on the positive side of variance.

In some ways I agree and disagree with him (more disagree ob). The market by nature and like poker is a game of incomplete information. Unlike, say chess, the information set needed in either poker or the stock market is not complete. Thus it is almost impossible to design a sophisticated algorithm running on a supercomputer with a teraflop performance that can play profitable poker, while Deep Blue and its cousin Blue Gene can always give Kasparov a run for his money.

I will try and highlight what I see as the biggest problems and of course potential remedies while trying to beat the market. I will talk primarily about hedge funds and retail investing, not about Mutual funds, as they have a bit of a disadvantage, being primarily LONG (but there are some top notch ones out there, Ken Heebner's CGM group of funds).

Now money is there to be made both in poker and the market. But key for both are the following:

(1) Bankroll management: This is absolutely critical. Bankroll management essentially refers to managing you roll/money/AUM. People get greedy and start placing bets way over their heads or way over their AUM limits via crazy leverages. The hedge funds that go down the drain and return 0$ to its investors for every $ invested are primarily guilty of this (and right now hedge funds are going down like pinballs) . It is hard to believe that funds supposedly run by such smart folks can make such horrible calls and place such atrocious bets. A recent case of a hedge fund's misfortune is this. The reason for the collpase of this family of hedge funds, Horizon funds, is the insanely crazy leveraged risks that the fund took. In some cases they were leveraged at 12:1 or more. While such huge leverage will print money in the first few years (Horizon returned 40% for the first 2-3 years) but it is a sure shot recipe of disaster (net assets turn to ZERO).

Another more bigger fall that highlights the poor bankroll management that hedge funds tend to practise is that of JWM Partners launched by Meriwether of Long Term Capital Management fame (i mean absolute infame). LTCM if people remember is that crazy hedge fund that was a yester-year bears sterns meaning that it was so big that it could not fail and had to be bailed out !! Details here. Now after the LTCM debacle Meriwether and his cronies having not learnt an iota of a lesson from thier past debacle, this time went about placing leveraged bets on mortage-related securities. And well once again they are close to being history, having pumped into the gutter more of investors' wealth (approx 1.4 billion). The story here.

(2) Atrocious bets: By definition a hedge fund is supposed to hedge risks, a market neutral hedge fund for example must always be that---> market neutral. But the reality is of course a bit more distant from that. Hedge funds are known to place some heavy and I mean really heavy bets on SINGLE POSITIONS, and in most cases via their star traders. So whatever the prospectus say, these HFs make some sorry ass bets that can turn against them faster than you can say bob's my uncle. Amaranth Advisors for example (I am choosing the famous/infamous ones here) had 50% of its portfolio (starting AUM of about 5-6 billion USD) bet on natural gas via their star commodity trader Brian Hunter. Such brash bets made huge returns in the first couple of years but then in one week of trading that 50% position dragged Amaranth's AUM down to 4.5 bill from 9 bill causing the fund to collapse.

I have heard and read that discpline is one of the first thing that a trader in a fund is instilled with --> Hedge your risks, dont fall in love with your positions, dont take leveraged risks, exit losing positions fast etc etc. But reality shows that discpline is something that the majority of the funds lack. Black Swans are supposedly once in a lifetime happening, but these days it happens once a few months !!! So for an outsider or an investor who sees these collapses, it is quite natural for him to turn extremely sceptic. But of course there are some good ones out there (though it is getting increasingly difficult to find the good ones) , SAC Capitals for example. But hedge funds can get bad to worse really fast when they forget the basic underlying principles of maintaining strict trading discipline and not making crazy bets (though it is very common, and driven almost exclusively by gut wrenching greed).

As for me Sales and Trading still remains a potential career option and poker continues to remain profitable. I am up over 20k YTD on the back of very very limited playing time. Touch wood.

Ooops this has turned into a huge post, part 2 later, part 2 will be for the retail investors..... one last parting word ---> there is nothing like self-learned knowledge, Wbuffet spends 99.9% of his time doing nothing but reading 10ks and 10Qs and prospectus.

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