By Rene Levesque
In the featured article The Secrets of the World’s Greatest Traders, author Jack Schwager makes reference to two key behavioral or personality characteristics of successful traders.
These are (1) “People who are successful traders will have the ability to quickly admit that they’re wrong;” and (2) “Discipline is also important.”
I could not agree more about these two observations.
Through the years, the hedge fund industry has attracted participants with elaborate experience with proven track records in the traditional asset management space. These market participants were previously evaluated, rated, selected, and dismissed on the ability (or failure) to derive Alpha. It is all about the Alpha, or excess units or returns obtained per unit of risk assumed to derive the returns, i.e. information ratio. In essence, their objective was primarily to provide returns in excess of the prescribed benchmark and/or to a defined peer group of managers. The means undertaken to achieve these objectives mainly consists in hard-earned fundamental analysis to identify and express non-consensus or divergent views to exploit un-discounted valuation gaps. As well, the capital at risk deployed into these ideas end up being proportional the underlying conviction level in the identified opportunity.
However, in the quest for absolute return, some elements are missing from the modus operandi normally deployed in the process of deriving Alpha. Basically, what good is a negative 14% when the market has lost 22%; it may be Alpha, but certainly not absolute returns. The missing elements specifically refer to Mr. Schwager?s observations on the behavioral or personality characteristics of successful traders. (Notice the reference to Traders rather than Investors).
Absolute returns, most simplistically explained, consists in deploying capital into ideas that are currently receptive to the overall market; and the discipline to retrieve back that capital (or reducing allocations) when the market is no longer receptive to the idea. Absolute return strategies dwell on “discipline.” This discipline refers to not being subjected to the temptation of two particular (and academically documented) behavioral biases: the disposition effect and overconfidence, i.e. admitting being wrong (even though one may be right in the thesis).
The Disposition Effect claims that investors are eager to sell stocks of value and willing to hold stocks that have lost value; they are unwilling to suffer or realize losses through disposition. Overconfidence reveals an investor’s unwillingness to discount available information while overestimating their private and hard-earned superior information. The concept is particularly applicable among professional investors who consider themselves competent experts.
As an example, this “discipline” represents exactly what the Systematic Global Macro managers are seeking to replicate. They will identify a trend according to pre-established rules, timeframes and algorithms, and implement a position in line with the directional trend and apply a trailing stop. This tailing stop spread essentially represents the premium they are willing to assume to participate in the trend, upward or downward. The systematic application of the algorithms effectively suppresses the mentioned behavioral biases.
In the traditional asset management space, or any Alpha-seeking framework, relying on an elaborate research process to express high conviction ideas subjects the portfolio manager to these specific behavioral biases. The deeper the due-diligence and the most non-conventional the ideas to identify hidden and misunderstood valuation, the more time required for the market to recognize, digest and eventually discount these valuations. And therefore, the most time required for the monetization of the time and effort invested by the portfolio manager and his team. Meanwhile, before these ideas can be monetized, other events and issues may impact the specific issuer or market as a whole. The long and expensive process required to validate and build conviction among these themes and ideas becomes “emotional.” And as the market fails to acknowledge and discount these high-conviction and significant valuation gaps, the portfolio manager working on his Winner’s Game will, for the lack of a better term, “disrespect” these market forces and most likely gross-up on his high-conviction ideas. “The market is wrong and I am right?”stubbornly admits the manager.
As Alpha-seeking mandates are most akin to “investing;” absolute return strategies are more about “trading.” The reference to trading pertains to active risk management, i.e. actively attending to and dealing with losing positions. This is in sharp contact to ?risk mitigation? which consists of hedging, diversification, pairing positions, market or beta neutrality. None of which offer a guaranteed to absolute returns.
Contrary to traditional Alpha-seeking asset management, the objective in absolute return strategies is not necessarily to be right, but to make money; and to protect capital when the market is no longer receptive to the well-researched ideas.
The focus on Alpha generation subjects the portfolio manager to the specific behavioral biases that alienate the strategy from generating absolute returns. Whereas the disciplined process in actively and rationally dealing with losing positions suppresses the behavioral biases. Hedge fund investors have unfortunately sought comfort in strategies relying on a risk mitigation framework (rather than active risk management) that subsidizes behavioral biases, and thereby only impedes the propensity to the protection of capital and the generation of absolute return.
The Alpha-seeking managers systematically bleed when markets dislocate, exhibit contagion, exogenous events, volatility, de-risking and liquidity dry-ups. These occurrences have become increasingly frequent and in some cases increasingly violent; thus the case in effectively overlaying Alpha-seeking strategies within a more disciplined framework in the deployment of capital and expressing ideas.
Mr. Schwager is indeed correct in his reflections on the attributes that do exhibit the most talented traders.