Hi Alex how’s it going? I follow you on Twitter, just want to say thanks for sharing your knowledge. Was wondering if you could go into a little more on portfolio construction/management pointers when running your macro book PA? Rather than talking about winning % etc, more on managing lines, correlation, hedging, direction, long/short gamma etc, running cores? Totally understand if you’d rather not but thought it would be good to learn from someone with your experience. Thanks

Thank you for following. I am in the process of writing a book, which will provide a more comprehensive view of my strategic approach. Hopefully it will answer some of your questions.

 It is not easy to provide a concise advice on the points you have listed as such strategic preferences are very individual. You are correct in being cautious about ideas provided in social media without a consistent intellectual/strategic framework. I’ll try to do my best.

Stay tuned.

Portfolio performance – size matters?

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”.
Good luck!
 

Great analysis on CHFUSD short. Here is my concern. Markets tend to retest fat finger/blowout levels. CHFUSD may retest the lows again in a few months. That would be a great entry point. Thanks for sharing you insights.

I agree. I am not a technician, but I fully accept that retesting the lows might happen. We don’t know if all the CHF pain is over. There might be more players still liquidating. My strategy dictates that I must have a position here, so that I don’t miss the value. But if it goes to the lows again – all the better – I would add there.

Specter of negative rates is haunting global bond math

Extreme, even absurd-sounding scenarios. Don’t feel foolish for including them in your reasoning. Sometimes one has to ponder the extremes to reach the utmost clarity.

The last week’s Swiss Franc move reminded to us that no one is safe in the markets. I could gloat and say “Look at me: I was wrong way around, but I actually did well because of my good risk management and portfolio construction!”

But, rather I am saying “Whew…”

In the world of leveraged finance one may not honestly say “My portfolio cannot blow-up.” Rather I would hear “My portfolio will not blow-up, unless U.S Government declares a full default… China goes to war with Japan… aliens invade…”

In the spirit of considering all scenarios, let’s talk about the bond markets.

One of the arguments I heard recently from people who wanted to be short U.S. government bonds is “With 10-yr note yield sub 2%, how much more can they rally? The risk is skewed to the rate upside.”

I take an issue with this approach. Let’s consider the true extremes.

1. All rates going to infinity. An event approximated by full default or hyperinflation. All future cash flows become irrelevant. All bond prices, regardless of maturity, go to 0.

The downside for a par bond is 100 to 0. Regardless of coupon.

2. All rates go to 0. An event approximated by establishing gold standard and no term premium. All future cash flows have the same value as present cash. Every bond is worth it’s face value plus all future coupon payments.

The upside of par 2-yr note with 0.5% coupon 100 to 101. Not much compared to the downside of 0.

However, the upside of 30yr par bond with 2.5% coupon is 100 to 100 + 2.5*30 = 175. Not so skewed, is it? 

Another way to think of it: if you have a zero-coupon bond trading at 50, the risk symmetric with respect to these two scenarios (0 with infinity rates, 100 with 0 rates).

This counterintuitive distribution of risk, has to do with “bond convexity”. The convexity is caused by the fact that, as rates fall, the future gains and losses become more meaningful when discounted to the present. Thus those who bet on falling rates see the size of their position increase, as the market moves in their favor. The converse is true with betting on rising rates. These convexity effects increase dramatically as the maturity of the bond lengthens.

3. Rates go negative. Not possible, huh? Tell this to Euroland, Switzerland and Japan. So far the negative rates dominate only the portion of the yield curves within the 10yr mark and the convexity effects are subdued. But who can now deny the theoretical possibility of negative rates all across the curve?

Can future sovereign obligations become multi-fold more valuable, just by the virtue of being the future?

The U.S. Treasury curve seems in no such immediate danger. At least in nor much more danger than EURCHF floor was from being released.

However, the United States has a fundamental structural difference from European markets – the fixed prepayable mortgage market.

Imagine the prepayment and refinancing wave that would happen if the 30yr mortgages rates started to head towards 0. Below 0?

The mortgages originators will find themselves immensely short fixed income market and forced to keep buying, exarcurbating the move.

Now the dealers are not stupid (mostly), they are hedging (somewhat) not only their directional risk, but also the convexity. But are they really prepared for negative rates? The thing with derivatives: for every party there has to be a counterparty. So, no matter how you push the risk around, it remains in the system.

And when people are caught unprepared, things get funky. U.S. economy might not warrant negative rates, but can the runaway convexity move take us up there? Could we theoretically see bond futures rallying say, to 1000?

Those are not likely scenarios. And I am not saying that you cannot trade bonds on the short side. We are in the business of taking risk.

But don’t say that bond upside is limited. And if you blow-up by being short, do it with your eyes open.

 

How did you know when the USD/JPY trade worked and thus would trend in your favor allowing you to increase positioning on corrections? What were the signs?

I don’t think there is one easy answer. When you start with just an unsustainable location, it helps to see the actual mechanism of change developing. In this case it was Abenomics. You can also read the chart to see when the new trend is established.

Is Swiss Franc the new BIG SHORT?

The dust has not yet settled from the shocking SNB decision to release the 120 floor on EURCHF. Something I had considered possible, but unlikely. 

In rare move for a developed country Swiss Franc appreciated 15%-20% (depending on when you choose to look at the screen) against most currencies.

Now what? Let’s forget about money we made a lost or in today’s commotion. What is the BIG CURRENCY TRADE for the next few years?

USDJPY  (short Yen) 2010-2014 was the most profitable trade in my career. But it feels mostly done, the way I was thinking about it at conception. Now a new wave of traders who believe in a massively stronger dollar needs pick up the baton.

Short EUR has been another great trade for me. But where it stands today at 1.16, it is long way down from 1.40.

Is Swiss the new BIG SHORT?

I know little of Swiss politics, but clearly no one thinks that such drastic currency appreciation will be good for Swiss markets. But does it in itself mean that the currency has to correct?

I believe it does, but I don’t know when and how.

In 2010 when USDJPY was in the low 80’s, I had concluded that the levels were unsustainable. I hadn’t known what the mechanism of Yen depreciation would be. But I initiated the trade, believing that the economic forces would sort the market out. I could not have foreseen the dramatic political shift of 2012 and the Abenomics.

However, what I need to remind aspiring Swiss bears – it took two year of waiting and 5-6% of downside pain for the USDJPY trade to play out.

Are you ready for the pain and for the waiting?

As many people are pointing out, QE is not as easy implement in Switzerland as it was in Japan. There is not enough sovereign debt to buy. And as the world is becoming more dicey the flows into CHF might increase.

So how will the Franc be able to depreciate? 

I don’t know how, but I believe it will. My inclination is to think that eventually they will find a way to print their own currency and weaken it. And maybe they will even overshoot.

Just don’t ask me about the time horizon and the downside.

i am initiating long USDCHF (short Swiss), but I am doing it with considerable caution and preparedness for pain.

i’ll sleep on it before deciding how far to commit.

Short both Euro and Yen, but trade them differently.

If you are a long-horizon macro trader there is a good chance you are short Euro or Yen, or both, like myself.

Indeed, the trend is in place and the stories of US economic outperformance and Central Bank policy divergence are strong in both cases.

Yet USDJPY trend is going strong now for over 2 years and has taken out all but most ambitious price targets. Meanwhile Euro has started to go down from 140 only a few months ago. And with parity being a commonly discussed target, it is still less than half-way there.

Am I telling you to get out of the JPY trade? No. Why give up a good trend? However, I treat this trade with a lot of caution now. I am definitely not adding on any pull-backs and incrementally reducing risk on over-extended USD rallies.

I am not technical trader, so I don’t to rely on trend-supports and corridors to stay in my position. I hate being whipsawed by technicals. So I ask myself, what will I do if there is major correction in USDJPY? The key to answering this question is if I have an opinion on where USDJPY will be say, two year from now or five years from now.

I find that is hard for me to have such such an opinion. JPY trends usually last at least 2-3 years, but even by such standards this one is mature. How will I be able to distinguish a correction from a trend reversal?

Thus “steady as she goes” on JPY, but not a focus of risk. And on a pull-back I am as likely to stop-out as to add. Note that recent price action would have made scaling-in profitable, but it is not a headache I am willing to face.

I have not short-changed myself though, because with Euro I AM willing to add on any pull-backs. The 5yr EUR forward is still above 1.31 as I am writing this. And my opinion is that it is going to be much lower in 5 years given what we currently know.

I am not too worried about corrections, because whatever the price action is, I believe that the economic gravity will pull Euro down eventually. The market will have a hard time persuading me that the trend is over.

An interesting consequence of this distinction is that I have to size EUR position very carefully to balance the following 3 goals:

1. Maximum profit in the event of rapid depreciation.

2. Ability to add on corrections.

3. Ability to hold the position through any imaginable price action.

Some of you might shake your heads – aren’t those goals mutually exclusive? Well, a jackpot like JPY from 80 to 120 is not easy to hit.

But bear in mind that if you are targeting 20-30% currency moves, your position does not have to that big initially. And if you are careful and methodical about pyramiding into a trend, you don’t have to expose yourself to any tight stops.