A Fund vs. Your Own Money

Hi Ash1972,

I think what you would learn is market making is a very good business. And an even better business when technology is applied and economies of scale kick in. Then an even better business when customer orders both market, resting and potential are used as leans for proprietary trades where this knowledge of order flow is the edge.

You know how difficult it is to generate pure alpha without the advantage of an order book so when you walk onto a huge investment bank or commercial bank trading floor and see dozens and dozens of “traders” you know the vast majority of them are not generating alpha as proprietary traders but instead use market making and leaning against flow to make money.

After market making/leaning against flow the next thing that gets classified as proprietary trading at an investment bank is what I call “naïve risk aversion”.

This is when an supposedly smart investment banker thinks volatility is risk and is thus so adverse to volatility risk that he takes on tons of other kinds of risk such as credit, liquidity, concentration, counter party etc to minimize the scary “volatility risk” and this is why Wall Street blows up every several years or so.

Also known as the "as long as I can't see a tiger he can't eat me" guide to jungle survival.

Personally in the general sense I view risk as Ben Graham’s definition that Risk is the permanent loss of capital (drawdown you don’t recover from) rather than Markowitz risk where risk is standard deviation i.e. “volatility”.

An example of the above is the 2008 credit crisis when Wall Street bought its own bullshit and warehoused tons of bundled ABS/MBS using firm capital to take on huge concentration risk rather than remaining diversified etc.

What I find amusing is when watching those government hearings where the Wall Street Investment bankers have to answer questions about what happened that they never just admit that they were just as stupid as the innocent and naïve customers.

It is hilarious that Wall Street bankers would rather be rather be seen as an evil genius pariah that sold garbage to naïve investors than let the secret get out that he is just as stupid as his customers since he had the same trade on. The difference is the taxpayer will bail out the banker but not the main street investor.

Still there are many guys on Wall Street working in investment banks that really know the business but if they can generate alpha inevitably they leave to start hedge funds and the stupid but brilliant political players end up running the Wall Street Investment Banks and after several years put on a similar huge concentration trade with the fashionable product de jour to avoid “risk/volatility” because this time its different and the cycle continues over and over.

And that is my explanation for it.

Anyway you also have to be impressed with Simons who uses market making camouflaged as proprietary trading without the Wall Street blowing up part to make billions and billions.

Obviously this rant shows I am not happy with the Italians.

Cheers Smoker

 

+10, nicely done.

A lot of realities captured there buddy.

 

This is one of the best points I've seen on ET in a while. Every trader should stick it to the wall. Seriously.

 

Very different when you are talking about managing OPM. When trading personal capital with an indefinite time horizon, you are correct in siding with Graham. But when trading OPM there is no such thing as a long time horizon during a loss, and the time period necessary to recover from a loss is not guaranteed.

What would be a temporary loss of capital in a prop account, becomes a permanent loss of capital in a fund because the timing of client redemption destroys the "inevitable" recovery you are relying on. My own system has such a consistent and strong positive expectancy, that a long term gain is all but certain. This does not equate to a risk free system for my clients as most would not be willing to sit through any extended period of under-performance.

Therefore, any time you are dealing with OPM, Markowitz's version of risk is more correct than Graham's.

 

Yes, but if think about it, client redemption occurs as a result of clients not understanding the risk in Graham's sense.

How many people bailed in panic during 2008/9 plunge instead of buying more on the panic peak or at least holding? Their funds would all be in the green by now, especially those invested in "real sector" companies, which inevitably were to recover sooner or later.

So this is more a question of perception of risk. But I certainly agree with you that many clients tend to run away during draw-downs to end up in red cursing the manager while things are back to good...

 

re bailing in the panic, there's a difference between having a stop loss (like 5 or 10%) and bottom ticking the mkt in march 09. saying they'd be in the green by now is irrelevant b/c there was a huge drawdown - esp if the manager "earned" management fees during that whole process. if you ran a billion dollar fund and charge 2% each year you would have been paid $20 million during the worst year (some funds lost more than 50%) for blowing up your clients.

re "real sector" companies - this is also irrelevant b/c you're not buying a company you're buying a stock. if you buy a "real sector" company and the stock goes down 75% do you tell your investors "it's ok guys ignore the loss it's a real sector company?" also a real sector company doesn't have to recover.

not trying to start a fight here b/c this is one of the higher value added threads out there - just saying that ignoring risk by not having a stop and blindly assuming every stock you own will always come back up to your purchase price is not a winning strategy.

 

Sure, neither I have intention to start a fight and myself strongly advocate use of strict position management in the form of cutting open losses as short as possible.

Talking more of the typical crowd mentality here (and the mentality of many Wall St. professionals, which turned out to be much the same as Smoker pointed out), which is not understanding what speculation business is. Wrong expectations, such as growth only and panic in a controlled, normal draw-down which often leads to realizing losses at the bottom. Of course if there is no sane risk management, then draw-down may be uncontrolled and panic makes sense.

Such a random behavior ironically leads to higher risk of net losses than disciplined approach. That's my point.

I perfectly understand what happened back in 08/9 from the managers point of view, they have to consider this crowd behavior effect and cope with it somehow.

 

There is a huge problem with this argument. The risk to the client and the risk to the adviser are very different. There is no way for the adviser to claim risk of 10% when the client is sitting on a loss of 20%. In fact, it is a really good way to get yourself thrown in jail.

Real risk is always based on maximum drawdown, because no guarantee can ever be given that there will be any recovery from that drawdown. To suggest to a client otherwise is misrepresentation and will ruin your career.

 

Good point from the legal and formal point of view. I almost have no experience of managing OPM, so it's something for me to remember. Thanks!

 

The only advantages come from economies of scale. Spreading out the high costs for quality information and technology is why trading firms exist. And it is a compelling reason, so think about it before you think about trading on a cheap computer with a cable internet and free broker software.