Tag Archives: trading

Review – The Art of Execution (@harriman, #investing)

The Art of Execution: How the world’s best investors get it wrong and still make millions (buy on Amazon.com)

by Lee Freeman-Shor, published 2015

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer. Find more reviews by visiting the Virtual Library.

Note: I received a promotional copy of this book from the publisher in exchange for sharing my thoughts AFTER reading it.

Professor Failure

What can we learn from failure? Aside from the fact that there’s an entire industry of business literature fetishizing the idea that it has much to teach us (as a kind of doppelgänger to the decades of success literature that took a person or business’s success as given and tried to look backward for an unmistakeable pattern that could’ve predicted it) I’m personally skeptical of what failure might teach. Life is complex and there is often little to separate the failure and the success but timing and luck in certain endeavors.

So, I approached Freeman-Shors book with some trepidation as the subtitle of the book suggests this is a study of failure. Au contraire, what we have here is actually a psychological or behavioral study, somewhat in the vein of Benjamin “you are your own worst enemy in investing” Graham, which studies not failure per se, but rather how investors respond differently to failure and thereby either seal their fate or redeem themselves.

A Behavioral Typology

The book recounts the investment results of several different groups of portfolio managers who were categorized, ex post facto, into various groups based upon how they reacted to adverse market conditions for stocks they invested in. The Rabbits rode most of their failed investments down to near-zero before bailing out and taking the loss. The Assassins had a prescribed set of rules for terminating a losing position (either a % stop-loss, or a maximum time duration spent in the investment such as a year or a quarter). The Hunters kept powder dry and determined ahead of time to buy more shares on a pullback (ie, planned dollar-cost averaging).

While I am suspicious of backward-looking rule fitting, I do think the author’s logic makes sense. What it boils down to is having a plan ahead of time for how you’d react to failure. The Rabbits biggest mistake is they had none whatsoever, while the Assassins managed to protect themselves from total drawdowns but perhaps missed opportunities to profit on volatility rebounds. The author seems most impressed with the Hunters, who habitually started at a less than 100% commitment of funds to a planned position and then added to their investment at lower prices when the market gave them an opportunity to do so.

Freeman-Shor’s point is that when the price falls on your investment you need to decide that something material has changed in the story or facts and you sell, or else you need to be ready to buy more (because if it was a good buy at $10, it’s a great buy at $5, etc.) but you can not just hang tight. That isn’t an investment strategy. This is why I put this book in the Benjamin Graham fold, the message is all about being rational ahead of time about how you’d react to the volatility of the market which is for all intents and purposes a given of the investing landscape.

Learning From Success, Too

The author goes over a couple other behavioral typologies, Raiders and Connoisseurs. I won’t spoil the whole book, it suffices to say that this section is worth studying as well because it can be just as nerve-wracking to try to figure out whether to take some profit or let a winner ride when you have one. Freeman-Shor gives some more thoughts based on his empirical observations of other money managers who have worked for him on when it’s best to do one or the other.

More helpfully, he summarizes the book with a winner’s and loser’s checklist.

The Winner’s Checklist includes:

  1. Best ideas only
  2. Position size matters
  3. Be greedy when winning
  4. Materially adapt when losing
  5. Only invest in liquid stocks

The last bit is probably most vital for a fund manager with redeemable capital.

The Loser’s Checklist includes:

  1. Invest in lots of ideas
  2. Invest a small amount in each idea
  3. Take small profits
  4. Stay in an investment idea and refuse to adapt when wrong
  5. Do not consider liquidity

Free e-Book With Purchase!

It is hard for me to decide in my own mind if this book is a 3.5 or a 4 on a 5-point scale. I think of a 5 as a classic, to be read over and over again, gleaning something new each time. This would be a book like Security Analysis or The Intelligent Investor. A 4 is a good book with a lot of value and a high likelihood of being referenced in the future, but not something I expect to get a new appreciation for each and every time I read it. A 3 is a book that may have been enjoyable overall and provided some new ideas but was overall not as interesting or recommendable.

While I enjoyed this book and did gain some insight from it, and I think the editorial choices in the book were bold, it’s closer to a 3 in my mind than a 4 just in terms of the writing and the ideas. I’ve found a lot of the content in other venues and might’ve rated it higher on my epiphany scale if this was one of the first investment books I ever read.

But something that really blew me away is that the publisher, Harriman House, seems to have figured out that people who buy paper books definitely appreciate having an e-Book copy for various reasons and decided to include a copy for free download (DRM-free!!) in the jacket of the book. This is huge. I read my copy on a recent cross-country flight and was really agonizing about which books from my reading stack wouldn’t make the trip for carry-on space reasons and then realized I could take this one with me on my iPad and preserve the space for something else. That’s a big value so I am going with a 4 as a result.


Post-Mortem: KVPHQ Capital Structure Arbitrage Trade ($KVPHQ, #CapArb)

A “valueprax” investment post-mortem explores the aftermath of a portfolio investment, successful or unsuccessful, with the intent of acknowledging the good, accepting the bad and attempting to find humor in the ugly. Success and failure alike carry valuable lessons; in support of the constant effort needed to avoid cognitive bias, the post-mortem is the table upon which all cards are laid and reality is fully embraced, rather than selectively avoided.

The Thesis

The thesis for this trade was elaborated upon in some detail in a series of posts over at CreditBubbleStocks.com. Essentially, KV Pharmaceuticals, the maker of an orphan drug called Makena which is used to treat pregnant women who have previously had complicated pregnancies, was the victim of a poor business model. They endeavored to charge $1,500/shot for a drug that could be easily replicated by pharmacists with generics for $10/shot. Physicians, the FDA and the government healthcare (Medicare/Medicaid) system all frowned on this behavior by the company by avoiding their products in favor of the generic alternative.

The result was a cash and earnings shortfall which left KV Pharmaceuticals with a challenged capital structure, summarized in an early post at CreditBubbleStocks.com:

There are two classes of common stock. The A class has a higher dividend but much smaller voting rights than the B class. The fully dilluted A+B share count is ~90 million, giving the company a $90 million market capitalization. Meanwhile, there are $225 million of senior secured notes due 2015 trading at 60 (market value $135mm) and $200 million of convertible notes due 2033 trading at 16 (market value $32mm). [In addition to various other obligations including payments owed to the previous owner of Makena.]

The nature of capital structure pricing and the legal force of competing claims within the capital structure dictate that discrepancies involving discounted debt and greater than de minimis common equity valuations can not be sustained over the long-run and the prices of these securities should eventually converge toward a common, non-contradictory narrative of the state of the business. Corporate debt trading at a significant discount to face value in the markets implies financial distress and a risk of insolvency, which further implies that common equity has no value, as the financial claims of debtholders are superior to those of preferred and common equity holders. Debt holders are due their principal at time of maturity, so if the bond market is saying they aren’t going to get all of their principal back it implies the equity holders have claims with zero economic value.

The Research & Analysis Process

Unlike an earlier cap-arb trade I did involving the securities of the now-bankrupt Energy Conversion Devices where I performed fairly extensive due diligence work on my own, in the case of KV Pharmaceuticals I simply grabbed the coattails of CBS and held on for dear life. “Research” involved following the postings on KV at the CBS website. “Analysis” involved considering what the posts were about and coming to terms with the argument for the cap-arb trade.

When I felt sufficiently comfortable with the thesis, I decided to place my bet.

The Execution

As with the previous cap-arb I did, the trade itself was theoretically simple but turned out to be technically complex. To set up the capital structure arbitrage the investor wants to buy the distressed bonds and synthesize a short on the equity. The belief here is that the equity is over-valued (assuming it’s worth zero) and the debt is under- or fairly-valued.

If the equity turns out to be worth something, the investor will lose on the equity short but gain on the debt long due to a full recovery. If the company is in fact insolvent and seeks bankruptcy protection with a zero equity value, the investor will gain on the equity short and could potentially lose on the debt long, though in practice it’s more common for the debt, already trading at distressed prices, to not lose a whole lot more in that situation.

I faced a couple challenges particular to this investment, the first being that the particular issue of debt I was looking for wasn’t widely available and took some time to come by. The second challenge was that the company was not that liquid and the options issuance (I wanted to synthesize a short by buying puts) available had wide bid-ask spreads and low volume and open interest.

This second aspect of the technical execution of the trade proved to be my folly.

The Experience & Lessons Learned

I didn’t double check this but I think I put the trade on originally back in May. I finally sold my puts (Sep 22 2012 2.50s) today. I still own the bonds, which are now trading at essentially a de minimis value, having lost approximately 90% of their value. Overall, the trade lasted about four months.

At the time I was placing the trade, I was traveling and not near a reliable internet/computer connection. That made researching securities and placing the trades incredibly challenging and stressful. In the future, I would not advise myself (nor anyone else) to attempt to place anything but the simplest of trades under such circumstances. It ended up resulting in me making a poorly informed decision (explained more below) and stressed me out during what was an otherwise enjoyable trip.

Another issue I faced is that I did not understand the technical details involved in pricing the option securities involved. I had trouble determining how many and which options I needed to buy to properly hedge my bond exposure and create the cap-arb. This is a limitation of my own understanding of option pricing theory which could have been remedied by intensive study of options reference materials which I decided I did not have time to engage in before or since I placed the trade. This is a behavioral issue– I admittedly did not understand the technical details of professionally executing this trade but assumed it would not be a big issue (probably, in my mind, relative to all the imaginary profits I’d be making when this thing went off with a bang).

The experience of being invested, itself, was fairly easy to endure in this case. KV’s business situation continued to deteriorate over the course of the trade. The company went through all the tell-tale signs of continuing, aggravated distress, including: falling share price, falling bond price (!), odd IR boilerplate related to trading activity, unfavorable announcements and news developments from regulators, etc., all the stuff you’d imagine would not be happening at all, especially not simultaneously, with a healthy company.

However, I again faced execution challenges when the company delisted its stock. I wasn’t sure if this was an appropriate time to “cover” and sell my puts, or if I should hold on, imagining they’d become even more valuable once the company delisted as I anticipated the stock price, already nothing more than a bloody stump, would be completely demolished following delisting.

In short, my lesson was that while I can follow the logic of a cap-arb thesis, I have real and continued shortcomings in terms of my knowledge of how to technically execute on the thesis which introduce significant risk into the equation. It is not the trade which was risky, it was me doing the trading.

That being said, I did come away with the sense that, while I am the right “scale” for opportunities like this (these inefficiencies exist because larger players won’t bother with them), without significant leverage, which may in fact be available through careful, expert use of options, these trades represent the opportunity to pick up pennies in front of a steamroller. If things go right and you’re not leveraged, you make a little money, but if you screw something up you can cost yourself even more.

The Outcome

In the end, the thesis was absolutely correct. KV Pharmaceuticals filed for bankruptcy protection in order to restructure their financial obligations. Their market cap fell from an initial ~$90M to the current ~$3.5M and the stock was delisted. Unfortunately, the debt I purchased also fell dramatically in value and right now it looks like the recovery on it will be pretty pathetic, if anything.

The trouble is, I didn’t technically execute well. I bought some in-the-money puts that were earlier dated (Sep 2012). I sat and watched my bonds get eviscerated even as it became clear there was no benefit in being hedged because the company was essentially a one-way trade (short) as they faced a going-concern issue. Meanwhile, the puts just didn’t perform because of what I paid for them– as they traded up a bit I didn’t receive much benefit because I bought at such a wide initial bid-ask spread. I probably could’ve more intelligently bought the puts so as to make a killing at this point in the game, but I didn’t know how to, that was beyond my expertise then and now.

Additionally, there were numerous points at which the puts were worth substantially more than what I ultimately paid for them (40-60% more at various points) but I never took advantage because I was greedy and assumed the share price would keep going down as everyone realized it was hopeless and the puts concurrently traded higher. Instead, volume dropped on the puts as people closed out their trades and the value of the options dwindled as they neared expiration (which is tomorrow). Fearing a total wipeout on the puts, I threw them into the market at market price this afternoon, happy to be rid of them and at a 20% profit.

Unfortunately, this was a fraction of what they had been worth at various points and was not enough to compensate for the loss in the bonds, such that even though the thesis played out as anticipated, I lost money on this trade.

I’ve learned my lesson now. I have one more cap-arb that’s ongoing and I’ll let it play out before selling. But I’ve realized I’m in over my head on this stuff and I don’t have the time and knowledge to get myself up to speed. I am my own worst enemy on this stuff, truly the biggest risk of permanent loss of capital lies within me.

With respect to that, I just won’t touch these kinds of trades anymore.

Review – Free Capital (#investing, @guy_thomas, #millionaires)

Free Capital: How 12 Private Investors Made Millions In The Stock Market (buy on Amazon.com)

by Guy Thomas, published 2011

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer. Find more reviews by visiting the Virtual Library. Please note, I received a copy of this book for review from the publisher, Harriman House, on a complimentary basis.

A methodical review of investors and their strategies

The greatest strength of “Free Capital” is its organization and layout– it’s truly like visiting an expertly-designed website in that the author has organized his investor interviews by four major descriptive categories:

  • geographers; top-down investors who begin with a macro thesis then look for companies and financial instruments which will benefit from that trend
  • surveyors; bottoms-up investors who start looking at individual companies and then sometimes check to see what kind of macro conditions might affect them
  • activists; investors who tend to get personally involved with their investments, taking large stakes and developing a close relationship with management
  • eclectics; people who don’t really fit any mold, but might be day-traders, value investors, sometimes activists, etc.

Within each categorical section are profiles of 12 (in total) investors that Guy Thomas spoke with, many of whom are anonymous, most of whom he came into contact with via investor message boards he participates on, and all of whom are UK-based and have managed to grow their capital into millions even over the last decade or less.

Though many were once employed by others and some came from financial backgrounds, all are now independent, full-time investors who live off of their investment returns and it is this kind of self-directed lifestyle and the resources which are needed to finance it that primarily lend themselves to the book’s title.

What’s really great is that in each chapter, Guy Thomas begins with a quick “tearsheet” profile of the investor’s strategy, key phrases, holding period, etc., then neatly organizes the interview material into background on the investor’s life and development as a financial person, outlines their strategy, experiences and any particularly demonstrative coups or failures they’ve enjoyed (or sufferred) and finally and extremely helpfully, summarizes all the material again in a table at the end with the major themes or ideas explored for quick reference.

As if this weren’t enough, Guy Thomas has written a lengthy (and for once, interesting) introduction to the book that serves as a combination summary of the main themes of the book as well as a how-to manual for those looking to get the most out of their reading. Thomas is correct in suggesting that the book can be read all the way through as a complete work, or explored at random based on what, if anything, sounds interesting to the reader.

It’s touches like this that show a thoughtfulness on the part of the author that leave the reader painfully aware of their absence in comparison to many other books in the genre. Frankly, it’d be nice if authors and publishers took Thomas’s lead on this point!

My favorite part: inspiration

I was excited to dig into the book in part because a friend had mentioned it to me and had commented favorably on it. He said a lot of the material covered wouldn’t be original but that I might find it inspirational to read other people’s stories of how they got where they are.

Maybe it’s where I am in my life right now, maybe it’s the subtle suggestion my friend made planted in my mind, or maybe it’s the shining spot for the book but the inspiration was one of the most important things I took away from the book. Some of the profiles were admittedly unhelpful (such as the day-trader, an investment style I can’t see any point in) or just not interesting to me (a few of the investors followed research processes I don’t have the time or motivation to emulate), but there were a couple I identified with, which made me feel empowered and hopeful about myself as I read them.

I particularly liked the two named investors, John Lee (who is a dividend-oriented value investor of sorts) and Peter Gyllenhammar (who bankrupted himself twice before hitting his stride and amassing his current fortune). I believe all of the investors lives and experiences illustrated this point well, but these two in particular were examples of the phrase “Patience is a virtue.” If a man can dust himself off after two bankruptcies and still make something of himself he can probably do just about anything given the time and the patience. Seeing as how I haven’t suffered personal bankruptcy (yet) I felt greatly advantaged to learn from this example of perseverance and triumph over failure.

Wise aphorisms

Another theme oft explored in “Free Capital” is the role simplicity plays in good investing. To that effect, I found a lot of great investing ideas captured in brief, simple aphorisms that made them both easily digestible and sufficiently memorable to make use of them myself in my own deliberations. Some examples include:

  • Good investing “requires only a few good decisions” (a helpful reminder given the way many seem to imply that a true investor is marked by the numerousness and hyperactivity of his ideas)
  • An activist is an investor who goes looking for trouble
  • “Quiet freedom is itself exotic” (in this way, independent investors lead quite adventuresome and even exciting lives!)
  • Exposure to some chances can only arise through deliberate and possibly unpopular and eccentric choices
  • Investment skill consists in not knowing everything, but in judicious neglect: making wise choices about what to overlook
  • Freedom is like income that cannot be taxed
  • To make good decisions, you need to look actively for reasons not to buy a company. And then invest only in those where you can live with the reasons
  • Time is a limited resource with strongly diminishing returns. The first hour you spend researching a company is much more important than the tenth hour
  • If an investment decision requires detailed calculations, you should pass, because it’s probably too close
  • The sun shines even on the poor man

Also of note is the author’s book-companion blog, which goes into a bit more detail on some of the investment themes captured in the book and which I’ve found to be a good supplement to the reading seeing that I was still interested to learn more even after I put it down.


“Free Capital” is a unique offering. It has a styling and organization that many books in its genre lack and I hope this effort is continued in any future titles from the author. And it treads original ground in profiling anonymous, “everyman” successful investors that no one has heard of yet who have interesting stories, experiences and lessons to share all their own. We can all learn from more than just Warren Buffett, after all.

It’s not without its flaws, of course. As the author himself states, the book doesn’t cover losing investors, people who took some of the risks investors profiled took, and failed, or who took other risks that didn’t turn out right, and then explores what lessons can be learned from their shortcomings. This probably could be a worthwhile book in itself, as there is a growing literature on “failure studies” and as the first lesson every investor must learn is “don’t lose what you’ve got”, learning of common mistakes to avoid could be helpful. Additionally, as an avid deep value (Benjamin Graham) guy myself, I could’ve done without the day trader and some of the other guys who seem like GARPy, momentum-based swing traders with short time horizons and questionable “value” metrics.

But those are minor quibbles and things that Guy Thomas could easily rectify by simply writing us more great books to read! Overall, “Free Capital” was entertaining, at times enlightening and best of all, extremely gracious with my free time as I read the entire thing in just three or four hours. Given the focus on the value of time in the book, I appreciated the fact that I could digest the meat of the book and walk away with some great insights to help my own investing… and still have time left in the day to get other things done!

Review – More Money Than God (#hedgefunds)

More Money Than God (buy on Amazon.com)

by Sebastian Mallaby, published 2010

A “valueprax” review always serves two purposes: to inform the reader, and to remind the writer.

A veritable pantheon of masters of the universe

Mallaby’s book is not just an attempt at explaining and defending the beginning, rise and modern state of the hedge fund industry (the US-focused part of it, anyway), but is also a compendium of all of the hedge fund world’s “Greatest Hits.” If you’re looking for information on what hedge funds are, where they come from, what they attempt to do, why they’re called what they are and how they should be regulated (SURPRISE! Mallaby initially revels in the success “unregulated” funds have had and feints as if he’s going to suggest they not be regulated but, it being a CFR book and he being a captured sycophant, he does an about-face right at the last second and ends up suggesting, well, umm, maybe SOME of the hedge funds SHOULD be regulated, after all) this is a decent place to start.

And if you want to gag and gog and salivate and hard-to-fathom paydays and multiple standard deviations away from norm profits, there are many here.

But that wasn’t my real interest in reading the book. I read it because I wanted to get some summary profiles of some of the most well known hedgies of our time — the Soroses and Tudor Joneses and such — and understand what their basic strategies were, where their capital came from, how it grew and ultimately, how they ended up. Not, “What’s a hedge fund?” but “What is this hedge fund?” As a result, the rest of this review will be a collection of profile notes on all the BSDs covered by the book.

Alfred Winslow Jones – “Big Daddy”

  • started out as a political leftist in Europe, may have been involved in U.S. intelligence operations
  • 1949, launches first hedge fund with $60,000 from four friends and $40,000 from his own savings
  • By 1968, cumulative returns were 5,000%, rivaling Warren Buffett
  • Jones, like predecessors, was levered and his strategy was obsessed with balancing volatilities, alpha (stock-picking returns) and beta (passive market exposure)
  • Jones pioneered the 20% performance fee, an idea he derived from Phoenician merchants who kept one fifth of the profits of successful voyages; no mgmt fee
  • Jones attempted market timing as a strategy, losing money in 1953, 1956 and 1957 on bad market calls; similarly, he never turned a profit following charts even though his fund’s strategy was premised on chartism
  • Jones true break through was harvesting ideas through a network of stock brokers and other researchers, paying for successful ideas and thereby incentivizing those who had an edge to bring him their best investments
  • Jones had information assymetry in an era when the investment course at Harvard was called “Darkness at Noon” (lights were off and everyone slept through the class) and investors waited for filings to arrive in the mail rather than walk down the street to the exchange and get them when they were fresh

Michael Steinhardt – “The Block Trader”

  • Background: between end of 1968 and September 30, 1970, the 28 largest hedge funds lost 2/3 of their capital; January 1970, approx. 150 hedge funds, down from 200-500 one year earlier; crash of 1973-74 wiped out most of the remainders
  • Steinhardt, a former broker, launches his fund in 1967, gained 12% and 28% net of fees in 1973, 74
  • One of Steinhardt’s traders, Cilluffo, who possessed a superstitious eating habit (refused to change what he ate for lunch when the firm was making money), came up with the idea of tracking monetary data, giving them an informational edge in an era where most of those in the trade had grown up with inflation never being higher than 2% which meant they ignored monetary statistics
  • One of Steinhardt’s other edges was providing liquidity to distressed institutional sellers; until the 1960s, stock market was dominated by individual investors but the 1960s saw the rise of institutional money managers; Steinhardt could make a quick decision on a large trade to assist an institution in a pinch, and then turn around and resell their position at a premium
  • Steinhardt’s block trading benefited from “network effects” as the more liquidity he provided, the more he came to be trusted as a reliable liquidity provider, creating a barrier to entry for his strategy
  • Steinhardt also received material non-public information: “I was being told things that other accounts were not being told.”
  • In December 1993, Steinhardt made $100M in one day, “I can’t believe I’m making this much money and I’m sitting on the beach” to which his lieutenants replied “Michael, this is how things are meant to be” (delusional)
  • As the Fed lowered rates in the early 90s, Steinhardt became a “shadowbank”, borrowing short and lending long like a bank
  • Steinhardt’s fund charged 1% mgmt fee and 20% performance fee
  • Anecdote: in the bloodbath of Japan and Canada currency markets in the early 90s, the Canadian CB’s traders called Steinhardt to check on his trading (why do private traders have communications with public institutions like CBs?)

Paul Samuelson & Commodities Corporation – “Fiendish Hypocrite Jackass” (my label)

  • Paul Samuelson is one of history’s great hypocrites, in 1974 he wrote, “Most portfolio decision makers should go out of business– take up plumbing, teach Greek, or help produce the annual GNP by serving corporate executives. Even if this advice to drop dead is good advice, it obviously is not counsel that will be eagerly followed.”
  • Meanwhile, in 1970 he had become the founding backer of Commodities Corporation and also investing in Warren Buffett; he funded his investment in part with money from his Nobel Prize awarded in the same year
  • Samuelson paid $125,000 for his stake; total start-up capital was $2.5M
  • Management of fund resembled AW Jones– each trader was treated as an independent profit center and was allocated capital based on previous performance
  • Part of their strategy was built on investor psychology: “People form opinions at their own pace and in their own way”; complete rejection of EMH, of which Samuelson was publicly an adherent
  • Capital eventually swelled to $30M through a strategy of primarily trend-surfing on different commodity prices; in 1980 profits were $42M so that even net of $13M in trader bonuses the firm outearned 58 of the Fortune 500
  • Trader Bruce Kovner on informational assymetries from chart reading: “If a market is behaving normally, ticking up and down within a narrow band, a sudden breakout in the absence of any discernible reason is an opportunity to jump: it means that some insider somewhere knows information that the market has yet to understand, and if you follow that insider you will get in there before the information becomes public”

George Soros – “The Alchemist”

  • Soros had an investment theory called “reflexivity”: that a trend could feedback into itself and magnify until it became unavoidable, usually ending in a crash of some sort
  • Soros launched his fund in 1973, his motto was “Invest first, investigate later”
  • Soros quotes: “I stood back and looked at myself with awe: I saw a perfectly honed machine”; “I fancied myself as some kind of god or an economic reformer like Keynes”
  • Soros was superstitious, he often suffered from back pains and would “defer to these physical signs and sell out his positions”
  • Soros believed in generalism: know a little about a lot of things so you could spot places where big waves were coming
  • Soros had a “a web of political contacts in Washington, Tokyo and Europe”
  • Soros hired the technical trader Stan Druckenmiller, who sometimes read charts and “sensed a panic rising in his gut”
  • As Soros’s fund increased in size he found it harder and harder to jump in and out of positions without moving the markets against himself
  • Soros rejected EMH, which had not coincidentally developed in the 1950s and 1960s in “the most stable enclaves within the most stable country in the most stable era in memory”
  • Soros was deeply connected to CB policy makers– he had a one on one with Bundesbank president Schlesinger in 1992 following a speech he gave in Basel which informed Quantum fund’s Deutschemark trade
  • “Soros was known as the only private citizen to have his own foreign policy”; Soros once off-handedly offered Druckenmiller a conversation with Kissinger who, he claimed, “does know things”
  • Soros hired Arminio Fraga, former deputy governor of Brazil’s central bank, to run one of his funds; Fraga milked connections to other CB officials around the world to find trade ideas, including the number two official at the IMF, Stanley Fischer, and a high-ranking official at the central bank of Hong Kong
  • Soros was a regular attendee at meetings of the World Bank and IMF
  • Soros met Indonesian finance minister Mar’ie Muhammed at the New York Plaza hotel during the Indonesian financial crisis
  • Soros traveled to South Korea in 1998 as the guest of president-elect Kim Dae-jung
  • In June 1997, Soros received a “secret request” for emergency funding from the Russian government, which resulted in him lending the Russian government several hundred million dollars
  • Soros also had the ear of David Lipton, the top international man at the US Treasury, and Larry Summers, number 2 at the Treasury, and Robert Rubin, the Treasury secretary, as well as Mitch McConnell, a Republican Senator

Julian Robertson – “Top Cat”

  • Managed a portfolio of money managers, “Tigers”
  • Used fundamental and value analysis
  • Once made a mental note to never buy the stock of an executive’s company after watching him nudge a ball into a better position on the golf green
  • Robertson was obsessed with relative performance to Soros’s Quantum Fund
  • Called charts “hocus-pocus, mumbo-jumbo bullshit”
  • Robertson didn’t like hedging, “Why, that just means that if I’m right I’m going to make less money”
  • High turnover amongst analysts, many fired within a year of hiring
  • Tiger started with $8.5M in 1980
  • A 1998 “powwow” for Tiger advisers saw Margaret Thatcher and US Senator Bob Dole in attendance
  • Tiger assets peaked in August 1998 at $21B and dropped to $9.5B a year later, $5B of which was due to redemptions (Robertson refused to invest in the tech bubble)

Paul Tudor Jones – “Rock-And-Roll Cowboy”

  • Jones started out as a commodity trader on the floor of the New York Cotton Exchange; started Tudor Investment Corporation in 1983, in part with an investment of $35,000 from Commodities Corporation
  • “He approached trading as a game of psychology and high-speed bluff”
  • Superstition: “These tennis shoes, the future of this country hangs on them. They’ve been good for a point rally in bonds and about a thirty-dollar rally in stocks every time I put them on.”
  • Jones was a notorious chart reader and built up his theory of the 1987 crash by lining up recent market charts with the 1929 chart until the lines approximately fit
  • Jones was interested in Kondratiev wave theory and Elliott wave theory
  • “When you take an initial position, you have no idea if you are right”but rather you “write a script for the market” and then if the market plays out according to your script you know you’re on the right track
  • Jones made $80-100M for Tudor Investment Corp on Black Monday; “The Big Three” (Soros, Steinhardt and Robinson) all lost heavily in the crash
  • Jones, like Steinhardt, focused on “institutional distortions” where the person on the other side of the trade was a forced seller due to institutional constraints
  • Jones once became the catalyst for his own “script” with an oil trade where he pushed other traders around until they panicked and played out just as he had predicted
  • PTJ never claimed to understand the fundamental value of anything he traded
  • PTJ hired Sushil Wadhwani in 1995, a professor of economics and statistics at the LSE and a monetary policy committee member at the Bank of England
  • PTJ’s emerging market funds lost 2/3rd of their value in the aftermath of the Lehman collapse

Stanley Druckenmiller – “The Linebacker” (my title)

  • Druckenmiller joined Soros in 1988; while Soros enjoyed philosophy, Druckenmiller enjoyed the Steelers
  • He began as an equity analyst at Pittsburgh National Bank but due to his rapid rise through the ranks he was “prevented from mastering the tools most stock experts take for granted” (in other words, he managed to get promoted despite himself, oddly)
  • Survived crash of 1987 and made money in the days afterward
  • Under Druckenmiller, Quantum AUM leaped from $1.8B to $5B to $8.3B by the end of 1993
  • Druckenmiller stayed in touch with company executives
  • Druckenmiller relied on Robert Johnson, a currency expert at Bankers Trust, whose wife was an official at the New York Fed, for currency trade ideas; Johnson himself had once worked on the Senate banking committee and he was connected to the staff director of House Financial Services Committee member Henry Gonzalez
  • Druckenmiller was also friends with David Smick, a financial consultant with a relationship with Eddie George, the number 2 at the Bank of England during Soros and Druckenmiller’s famous shorting of the pound
  • Druckenmiller first avoided the Dot Com Bubble, then jumped aboard at the last minute, investing in “all this radioactive shit that I don’t know how to spell”; he kept jumping in and out until the bubble popped and he was left with egg on his face, ironic because part of his motivation in joining in was to avoid losing face; Druckenmiller had been under a lot of stress and Mallaby speculates that “Druckenmiller had only been able to free himself by blowing up the fund”

David Swensen & Tom Steyer – “The Yale Men”

  • Swensen is celebrated for generating $7.8B of the $14B Yale endowment fund
  • Steyer and his Farallon fund were products of Robert Rubin’s arbitrage group at Goldman Sachs; coincidence that Rubin proteges rose to prominence during the time Rubin was in the Clinton administration playing the role of Treasury secretary?
  • Between 1990 and 1997 there was not a single month in which Steyer’s fund lost money (miraculous)
  • Farallon somehow got access to a government contact in Indonesia who advised Bank Central Asia would be reprivatized soon and Farallon might be able to bid for it
  • Some rumors claimed Farallon was a front for the US government, or a Trojan horse for Liem Sioe Liong (a disgraced Indonesian business man); it is curious that Yale is connected to the CIA, Farrallon is connected to Yale

Jim Simons & Renaissance Capital – “The Codebreakers”

  • Between the end of 1989 and 2006, the flagship Medallion fund returned 39% per annum on average (the fund was named in honor of the medals Simons and James Ax had won for their work in geometry and number theory– named in honor of an honor, in other words)
  • Jim Simons had worked at the Pentagon’s secretive Institute for Defense Analyses (another possible US intelligence operative turned hedgie?)
  • Simons strategy was a computer-managed trend following system which had to be continually reconfigured due to “Commodities Corporation wannabes” crowding the trades by trending the trends
  • Simons looked to hire people who “would approach the markets as a mathematical puzzle, unconnected to the flesh and blood and bricks and mortar of a real economy” (this is distinctly different than the Graham/Buffett approach, and one wonders how this activity is actually economically valuable in a free market)
  • “The signals that we have been trading without interruption for fifteen years make no sense. Otherwise someone else would have found them.”
  • Renaissance treated employee NDAs like a wing of the CIA– anyone who joined could never work elsewhere in the financial industry afterward, and for this reason they specifically avoided hiring from Wall St in the first place; they were required to invest a fifth of their pay in the Medallion Fund and was locked up as bail payment for four years after they departed (money hostage)

David Shaw & D.E. Shaw

  • Began trading in 1988, the same year as the Medallion fund
  • Shaw was originally hired by MoStan in 1986 into their Analytical Proprietary Trading unit which aimed at beating Steinhardt at his block-trading game using predictive computer technology
  • In 1994, Shaw’s 135-member firm accounted for 5% of the daily turnover on the NYSE
  • Jeff Bezos, of Amazon, was originally a DE Shaw employee
  • The strategy was heavily reliant on pair-trade “arbitrage”, looking for securities in similar industries which were temporarily misaligned in price/multiple
  • Circle of competence: in 1995 the firm launched the ISP Juno Online, as well as FarSight, an online bank and brokerage venture

Ken Griffin & Citadel

  • Created in 1990, grew to $15B AUM and 1400 employees by 2008
  • Griffin’s goal was to develop an investment bank model that could compete with traditional, regulated ibanks, but which was actually a hedge fund
  • Flagship funds were down 55% at the end of 2008, losing $9B (the equivalent of two LTCMs)

John Paulson

  • Paulson graduated from HBS in 1980 and went to work for Bear Stearns; he launched his hedge fund in 1994 with initial capital of $2M which grew to $600M by 2003; by 2005 he was managing $4B
  • Paulson’s main strategy was capital-structure arbitrage
  • He looked for “capitalism’s weak spot”, the thing that would blow up the loudest and fastest if the economy slowed even a little; cyclical industries, too much debt, debt sliced into senior and junior tranches, risk concentrated
  • Paulson spent $2M on research related to the US mortgage industry, assembling a proprietary database of mortgage figures and statistics
  • Many of Paulson’s investors doubted him and threatened to pull capital in 2006
  • Paulson enlarged his bets against the mortgage market through derivative swaps on the ABX (a new mortgage index) and eventually acquired over $7.2B worth of swaps; a 1% decline in the ABX earned Paulson a $250M profit, in a single morning he once netted $1.25B
  • By 2007, he was up 700% net of fees, $15B in profits and made himself $3-4B


I’m actually even more bored with this book having finished typing out my notes than I was when I finished the book the first time I read it. The book actually has some great quotes in it, from the insane delusions of grandeur of government officials and central bank functionaries, to wild facts and figures about the statistical trends of the hedge fund and financial industries over the last 60 years. I am too exhausted to go back and type some of it out right here even though I kind of wish I had some of the info here even without an idea of what I’d use it for anytime soon.

My biggest takeaway from MMTG is that most of these masters of the universe have such huge paydays because they use leverage, not necessarily because they’re really good at what they do. Many of their strategies actually involve teasing out extremely small anomalies between asset prices which aren’t meaningful without leverage. And they’re almost uniformly without a meaningful and logically consistent understanding of what risk is– though many are skeptics of EMH, they seem to all see risk as volatility because volatility implies margin calls for levered traders.

There were so many displays of childish superstition. Many of these guys are chart readers. The government intelligence backgrounds of many was creepy. And it was amazing how many relied on informational asymmetries which are 100% illegal for the average investor. These people really travel in an elite, secretive world where everyone is scratching each other’s backs. How many one on one conversations have you had with central bank presidents? How many trips to foreign countries have you been on where you were the invited guest of the head dignitary of the country? Are you starting to put the picture together like I am?

Overall, it seems so arbitrary. The best word that comes to mind to describe these titans and their success is– “marginalism”. We have lived in an inflationary economy for the last 60+ years and these players all seem to excel in such an environment. But inflationism promotes marginalism; the widespread malinvestment of perpetual inflation confuses people looking to engage in real, productive economic activity, and paper shuffling necessarily becomes a high value business.

The author himself is incredibly ignorant of economic fundamentals and the role monetary intervention plays in the economy. All of the various crises these hedgies profited from seem to come out of nowhere according to his narrative. The incredible growth in volumes of money managed by the hedge fund industry over time goes without notice, as if it was just a simple, unexceptional fact of life. Shouldn’t that be interesting? WHY ARE THERE HUNDREDS OF FIRMS MANAGING TENS OF BILLIONS OF DOLLARS EACH? Where did all this money come from?!

That makes the book pretty worthless as it’s key.

One thing that does strike me is that many of the most successful, most levered trades of Soros, Druckenmiller and others were related to currencies. These guys are all Keynesians but they probably don’t fully believe their own economic theories. However, they do understand them well enough to make huge plays against the dope money managers who DO put all their credence into what they learned at university. I should think an Austrian econ-informed large cap macro fund would have quite a time of it playing against not only the dopes, but the Soroses of the world– they’ll get their final comeuppance as this system of artificial fiat exchange finally unwinds over the next decade.

And, little surprise, the guy with the nearly perfect trading record for almost a decade (Farrallon) was involved in arbitrage trades.

Trend following is for slaves. It may have proven to be a profitable strategy (with gobs of leverage) for the contemporary crop of hedgies but I feel fairly confident in saying most of these guys will get hauled out behind the woodshed in due time if they keep it up, to the extent their strategies truly are reliant on mystic chart reading and nothing more.

Bon voyage!

Notes – AlephBlog Digest #1 – David Merkel On Corporate Bonds (@alephblog, #bonds

David Merkel, author of the AlephBlog, has an extensive background on Wall Street and is something of a value investor when it comes to his money management principles. There is a lot of good content on his site in various disciplines within the investment analysis and money management domains so this will likely be the beginning of a multi-part digest series. This one deals with his lessons about the corporate bond market. To read the entire original discussion, please click the title heading of each section.

The Education of a Corporate Bond Manager, Part I

How I learned the basics, and survived 9/11.

  • “Bond swap”– trading away an older bond of a company for a new issue
  • New deals almost always came cheap
  • Think about bonds as a put option on the equity
  • When selling a bond, look at what investment banks ran the books of the deal
  • Never make it look like there are two sellers (by working with two banks) or bids will vanish; bad etiquette to employ two banks without telling them they’re in competition with one another

The Education of a Corporate Bond Manager, Part II

How I learned to trade bonds, and engage in intelligent price discovery.

  • If you want to buy a bond not presently offered, find out who brought the deal and made a market in the bond issue
  • Price discovery toolkit:
    • Comparable bonds in the same industry
    • Credit spreads across rating categories
    • Credit spreads across the maturity spectrum within rating categories
    • Spreads on CDS on the same name
    • Value of scarcity vs cost of liquidity
    • Proper spread tradeoffs on premium vs discount bonds
    • Calculate spread on last few trades
  • There is a price to gain liquidity that the issuer pays
  • “One-minute drill” creditworthiness check on Bloomberg:
    • GPO, how has the stock price moved over the last year?
    • HIVG, how have option implied volatilities moved of late?
    • CH6, how is operating cash flow?
    • DES, what industry is it in?
    • DES3, major financial ratios of the company
    • CH2 or ERN, earnings declining?
    • CRPR, credit ratings?
  • If these tests are passed, odds of company doing badly while waiting for a credit analyst’s opinion are slim

The Education of a Corporate Bond Manager, Part III

What is the new issue bond allocation process like, and what games get played around it?

  • Speed of decision process when buying new bond issuance based upon:
    • complexity of deal
    • creditworthiness of issuer
    • speculative nature of market
  • When market runs hot, odds rise that the syndicate will overprice a deal and deliver losses to those asking for overly large allocations
  • Dealing in the gray market has taint, you don’t want to be seen doing it lest your allocations be reduced
  • Syndicates want to place bonds entirely with long term holders if they can, implies they priced it right, leaving little money for speculators

The Education of a Corporate Bond Manager, Part IV

On the games that can be played in dealing with brokers.

  • Poker aspects of the bond market:
    • be honest, keep your word on trades, don’t weasel out once you say “done”
    • have a fair reputation, that you don’t try to pull fast ones on the broker community
    • reputation for fairness should be reinforced by other actions
      • if ibank quotes price/spread out of market context, let them know what you know; only trade against them if they insist they’re right
      • if risk control desk comes to you with a trade to cover a short and you own the bonds, help them; make them pay a little more than the ask but don’t gouge, then they might offer you the long cross-hedge bond at a nice price
    • have an “openness policy”; reveal 80% and conceal 20%, the most critical 20%
    • your broker at the ibank is proud of his best clients; he doesn’t want to lose you if you’re bright, trade a lot, run a big account
    • never tell your whole story to any broker; break up your business among many brokers, with no overlap
    • it’s good to have a reputation for being bright, or at least not a pushover
  • It’s freeing to not think about whether a particular trade will generate a gain or a loss but rather how the portfolio can be improved

The Education of a Corporate Bond Manager, Part V

On selling hot sectors, and dealing with the dirty details of unusual bonds.

  • It takes time and effort to farm, but financial products can be whipped up in any season
  • If I am underweight, someone else must be overweight versus the index; someone has to absorb all the paper of a hot sector, don’t let that be you
  • Credit analysts understand the creditworthiness of bonds; what do PMs understand?
    • portfolio composition vs needs of the client
    • trading dynamics of the marketplace, whether good bonds might temporarily be mispriced
    • dirty details of the bond; covenants, terms, etc.
  • A lot of value is added by document review; in a time of panic, those insights are golden because other managers toss out illiquid bonds they don’t fully understand

The Education of a Corporate Bond Manager, Part VI

On dealing with ignorant clients, and taking out-of-consensus risks.

  • Optimal strategy for life insurers: interest spread enhancement with loss mitigation
  • Defaults are a fact of life; if you run with such a thin capital base that you can’t survive a few modest defaults, you’re running your insurance company wrong

The Education of a Corporate Bond Manager, Part VII

On the value of credit analysts.

  • Credit analysts are a corp bond mgrs best friend
  • Provide a necessary check on a PM trying to play “cowboy” and be a yield hog
  • Native tendency is to reach for yield:
    • a portfolio with more yield earns more
    • a higher yielding credit will rally, due to mean-reversion
  • The second is true about 50% of time, but rewards are assymetric; gains are small, losses are large– it doesn’t pay to be a yield hog
  • All analysts have biases; to overcome, give them a list of spreads for companies they cover and ask them to rank the credits in that sector
  • For Mr. Yes, ask him about risk factors; for Ms. No, ask what are the best names she’d invest in
  • Every investment shop tends to create a monoculture modeled off the PM at the top; to avoid bias:
    • have multiple analysts look at a conviction idea
    • have PM take it home and analyze it
    • look at Street research to find bears, and circulate the opinion to the team

The Education of a Corporate Bond Manager, Part VIII

On price discovery in dealer markets, and auctions gone wrong.  I never knew that I could haggle so well.

  • There may be 7000 actively traded stocks in the US but there are nearly 1,000,000 bonds, the last trade of which may have been a week or a month ago
  • After adjusting for default risk, the number one predictor of portfolio return is yield
  • Default risks are lower after the bust phase of the credit cycle, rise as the credit cycle gets long in the tooth
  • David does a trade: “But how to come to the right price/yield/spread?  I had a few trades, but they were dated.  I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today.  I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question.  I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds.  The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell.  If a trade, I would back up my bid a little more, and offer to buy more.  If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.”
  • How to have a successful auction of bonds you own:
    • limit auction to dealers who have most interest
    • say you’re just raising cash, eliminates information risk, makes them willing to bid
    • cover level is the second place bid
    • can’t come back begging for love
    • ties are fine; no love, both brokers get half
    • not enough bids, cancel it
  • Limits to haggling: when you’re already getting an unreasonable deal, smile, say thanks and move on; it’s more important to be invited back
  • Bid/offer fewer bonds than wanted by the seller/buyer at the level, and ask for better terms at their size; makes them more willing to deal
  • Always pay your brokers, it makes them more loyal to you
  • Trading is an amplified version of character; try to be fair everywhere you can while still making money for the client
  • Playing for the last nickel costs 95 cents in the long run

The Education of a Corporate Bond Manager, Part IX

On the vagaries of bulge-bracket brokers, and how a good reputation helps on Wall Street.

  • You aren’t supposed to act like a market-maker; if it’s known you aspire to risk-free profits, they might use their power to hurt you:
    • lower allocations on new deals
    • tougher in haggling
  • Reputation matters
  • Gravitate secondary trading business to those who “walk the walk”

The Education of a Corporate Bond Manager, Part X

On how we almost did a CDO, and how it fell apart.  Also, how to make money in the bond market when you reach the risk limits.

  • You can only do deal #2 if you’ve done deal #1
  • Macro theme: stability usually triumphs over discontinuity

The Education of a Corporate Bond Manager, Part XI

On my biggest mistakes in managing bonds.  Also, on aggressive life insurance managements.

  • Bonds are assymetric
  • Paid to be cautious regarding failure
  • When in doubt, sell
  • Don’t always take your broker at face value

The Education of a Corporate Bond Manager, Part XII (The End)

On bond technical analysis, and how to deal with a rapidly growing client.   Also, the end of my time as a bond manager, and the parties that came as a result.   Oh, and putting your subordinates first.

  • On timing purchases and sales:
    • the large brokers generally know who is doing what
    • be nice to sales coverage, you’d be amazed what they’ll tell you
    • keeping the VIX on screen helped accelerate or slow down purchases and sales in a given day; yield spreads lag behind option volatility
  • On time horizons:
    • Three horizons
      • daily
      • weekly-monthly
      • credit cycle
  • On scaling:
    • moving in and out of positions slowly, as market conditions warranted, is useful
    • “Never demand liquidity unless it is an emergency and you meet the strenuous test that you know something everyone else does not. But, make others pay up for liquidity where possible. You are doing them a service.”