Purists insist that it is all about percentages. How much you are making in actual dollars doesn’t matter. Then they correct themselves: actually percentages are not enough either – they need to be normalized by volatility. So it is Sharpe ratio that matters. Or some other ratio.
Let’s step back for a second. I am talking about evaluating a portfolio performance. I don’t live in the world of benchmark or indices. I speak what I know of: leveraged and dynamic hedge fund style portfolios which are not supposed to be correlated to any particular asset class whatsoever.
As a side note, have you ever noticed that we are also drawn to analyze and review our past numbers especially carefully after a period of GOOD performance. When things go south we spend more time thinking of margin calls than track records. I must be doing well to write this post.
So, first, let’s define what it means to be doing well. I will introduce a distinction (just for the purposes of this piece) between a good money manager and a good trader.
A good trader is somebody you want to be trading with your money.
A good manager is somebody you want to be you business partner.
A good manager has skills a trader doesn’t need: managing and building businesses , finding good PMs, finding and retaining investors, negotiating credit lines and margins. If I traded $1mm and returned 800% return, I still couldn’t claim to be a more successful money manager than somebody who has AUM of $10bln, returns gross 8%, charges 2/20 and still convinces investors that they are getting a great deal. If you doubt who is more successful do the “take home money” math.
Thus far, my credentials as a trader far exceed my credentials as a money manager, so once again I’ll focus on what I know best. Especially since most investors should focus on who is actually a better trader.
I want to discuss the issue of portfolio size, as well as the related issues of Personal Account versus Client Money trading and lifetime aggregate track record.
If a trader manages a portfolio for 20 years under more or less consistent terms and conditions, and trades nothing else – this is the time to bring your risk metrics. While “past performance doesn’t guarantee future performance”, you can still form a pretty good opinion on how they HAVE DONE thus far.
So does size matter?
Once a pitched a trade to my boss. “How much money do you think we’ll make?” he asked.
“About ten million.”
“Let’s do twice more and make twenty.”
Over years I have met and interviewed traders who demonstrated an amazingly consistent performance on a small risk, but could never break out on a larger scale. There could be a few reasons for this:
– Their bosses were not allowing them to take more risk
– They were not emotionally capable of taking more risk
– Their strategy was not scalable.
Let’s talk about scalability. Most of my lifetime profits came from highly liquid products, such as developed markets interest rates and currencies, so scalability has rarely been my concern.
If you have a diversified strategy, increasing scale is a double-edged sword. You risk more slippage – not being able to get the amounts you need without moving the market. But on the other hand, when you manage a big portfolio, you usually enjoy better commision deals and better information flow and service from market makers. Overall I think those factors cancel out.
However, I believe that when you try to evaluate whether a certain trader is “for real”, it definitely helps to know if they have delivered performance on large portfolios. Here are some reasons:
– If somebody is managing a lot of money that means they either made or raised a lot of money already. It could be totally undeserved, but all else being equal the odds are they have done something right.
– If they are managing a big portfolio, there is a lesser chance that they are a “one-trick pony” (relying on some idiosyncratic and transient market condition).
– They have escaped illiquid blow-ups. Did I just say slippage is not that important? It’s true in normal markets: the liquidity is always there when you don’t need it. But when catastrophic events unfold, portfolio size suddenly might matter very much. And, anybody, who managed a large portfolio for years, has probably had to deal with some painful and complex unwinds.
So my conclusion: not only percentages and risk ratios, but also absolute dollars matter in terms of lifetime performance.
Now i will shift to some questions, to which I don’t have a good answer.
Over my 18-year career, I have held several market-making positions, engaged in proprietary trading in a bank, ran a hedge fund, and traded a personal portfolio. Clearly, if someone wanted to evaluate me, they would want to look at an aggregate performance over of all those endeavors.
Have you ever heard something like “I deliver a consistent 20% return, except for that one time, when I blew up”? I don’t want to be someone saying this.
Purists will say: “You must compound the performance of all portfolios you ever managed personal or client, regardless of size”. We’ll be lucky if they don’t count divorces and yacht purchases as legitimate drawdowns.
Fortunately, I find myself able to say “I deliver 15-20% risk-normalized return (or Sharpe ratio above 1), by any reasonable measure and that is including all career bumps”.
I can say that, but can you verify my returns?
Let’s say, I showed you my last year’s broker statement:
Sharpe ratio: 5.5
You would be correct to ask the following questions:
– How many data points are there on this statement ? (only 12 monthly points)
– Has this strategy delivered comparable reruns over the last 5 years? (it didn’t)
– Do you have other portfolios? Illiquid investments? Real estate? (I do)
– Did you other investments perform as well as this other portfolio? (they didn’t)
So what do you actually know from this statement?
Now if such scrutiny is required, let’s go to the extreme.
Consider a trader who accumulated $100mm of personal wealth working for banks or hedge funds. Now they purchase some real estate make some other personal investments and set aside $25mm to start a hedge fund. The HF raises $150mm and a year later proceeds to blow up to 0.
The trader moves on to other endeavors with still quite considerable personal account. And maybe even makes a lot more money in the future.
If you just compound up the performance you might end up with an absurd result that from now on this trader’s lifetime return in ZERO no matter what.
And maybe there is a case to made: some would say that someone who took a client portfolio to zero never again deserves investors.
I view the situation my complex. I don’t know exactly to incorporate a person’s success at managing their own wealth into the investors’ evaluation. But this particular trader has done well overall, even they have tanked one portfolio.
I might choose this trader over someone who has consistently made small amounts. Why? Because I may believe the portfolio that blew up was a decent proposition: it blew up, but it had a good upside and a good expectation. And the fact this person has managed to accumulate and retain wealth despite bumps, makes me think they will continue entering good propositions.
I believe that they there two factors to be considered beyond risk measures, with their well known flaws:
1. Lifetime absolute trading dollars
2. Lifetime personal traders dollars (combined personal gains, incentive fees, and bonuses).
If the person has done well with those two – at least you know they are “for real”.