Building The Marvelous Money Machine

Broader comments on hedge funds

noreply@blogger.com (Keith) — Tue, 12 Feb 2008 18:55:00 +0000

Sorry we've been away for a little while. This round of investments has taken up lots of time (and lots of computing power). We are already planning for a technology upgrade at some point. The analytics we are running are maxing out our systems already, so look for more powerful computers soon. But so far so good, we are up again this month.

Not so for 3/4 of hedge funds in January, according to comments made by Barclay yesterday. According to Barclay, over 900 hedge fund managers out of the 1241 in its database lost money in January. So much for the hedge fund being perceived as a vehicle that can change directions quickly, I guess. January was a tough month for sure, but it's hard to believe that so many funds lost money. Many of those that should have never been created have forgotten their mandate, or never knew it to begin with. You have to try to make money all the time, every month. No one can do that forever, certainly not us. There will be months where your best efforts don't work out. But the loss has to be minimal, like 1 or 1.5% down. Some of these funds were down 8%, 12%, or even more during January. That's not hedging, that's gambling. Or it's maintaining conviction in the face of negative information. Either way, it's wrong.

We will never be up 100% for the year, not in this fund anyway. It's not built to hit a grand slam. But it is designed for singles and doubles and the occasional triple. It's all about on-base percentage and executing good fundamentals. Enough of the baseball analogy.

Let's hope that some of these funds regain their senses and remember why they are really in business. It's not to take big bets and get paid off huge if you are correct. It's about being wrong a very small percentage of the time by hedging every move you make.

Jump On It

noreply@blogger.com (Keith) — Wed, 06 Feb 2008 03:45:00 +0000

Dow down 370 - means we are making a move. Stay tuned...

Next Investment Round

noreply@blogger.com (Keith) — Thu, 31 Jan 2008 19:19:00 +0000

Our next round of investments is about to begin. The arrival of the Blooomberg a week ago ended our short period of operating in degraded mode. Now we are about to unleash the full operational power of this process. OK, that is a little dramatic. Let's just say we've got all the tools that go in the toolbag now.

On a broader note, the market is looking like it will finish January down about 6.5%. That's better than the -13.5% it touched intraday about ten days ago, but all is not well with the economy. The Fed has cut rates 1.25% in the last ten days, which has provided most, if not all, of the comeback. But the effects of those cuts will take a lot of time to ripple through to income statements, and in the meantime, it could be choppy. As it turns out, we like choppy. We make more money in general when the smooth sea turns into a rough storm. But choppy normally means that most people are hurting for awhile.

We called a range for the S&P for 2008 between 1300 -1550. We haven't closed below 1300 yet, although we've been there twice intraday. Hopefully we can get closer to 1400 soon. I have a feeling that the market will finish slightly positive for the year even given this rocky start.

The Roof Is On Fire

noreply@blogger.com (Keith) — Mon, 28 Jan 2008 16:24:00 +0000

More negative news came out this morning about the sales of new homes, about how they are at their lowest level in 12 years, blah blah blah. Well, we all knew this was coming in 2005. There is no free lunch. Things got ridiculous, everyone jumped in, things went sour, now people are scared and want answers. In other words, the same old story of any bubble.

So here's an answer: The time to invest in residential real estate, whether for your personal home or for you investment portfolio, will be in the next 18 months. That's not the answer most people want to hear, because many have been left holding the bag (or the deed, or whatever). But if you want to make a good investment, 2008-2009 is the time to buy fairly low. We need to see blood in the streets. We need to see grey matter oozing out of people's ears. We need unearthly shrieks of pain. And we are starting to get near that point.

Homebuilders are laying off people right and left. Many subcontractors are waiting for phone calls that aren't coming. Rate cuts and refinancing aren't going to save a lot of people; they are going to have to dump their home at the worst possible time and at the lowest price. We aren't taking any pleasure in this, it's an awful thing for people to endure. But they knew what they were signing up for when they got their 5/1 ARM at 3.85%. There is always a day of reckoning.

Positive!

noreply@blogger.com (Keith) — Thu, 24 Jan 2008 17:46:00 +0000

We don't talk about exact performance here, but I'm happy to report that our first month will be a positive one, even with all of the market turbulence. Our hedges were bent a little, but unbroken, and we will be positive. How do I know this, with a full week left in the month? Because our Bloomberg just got here today, and we are sitting in cash while we run the analytics to put together our positions. This will take a few days, and we want to make sure we are following all of the procedures that have worked in the past. Plus, Bloomberg has upgraded lots of the analytic tools, and there is a small learning curve in place.

Rogue Trader or Rogue Firm???

noreply@blogger.com (Keith) — Thu, 24 Jan 2008 17:36:00 +0000

One trader wiped out $7.1 billion of capital from Societe Generale over the past two years.

They just noticed it this week, when the turmoil in the markets forced the trader to cover his bets.

You would think that after all of the rogue traders that have brought down firms (Jett, Leeson, etc.) that institutions would have tightened up these risk controls. Ummm, not a chance. This guy was allowed access to systems that allowed him to cover his tracks for years. The firm never questioned anything until it was too late. That's why compliance is so important, but especially to the big firms. It's easier to hide a mistake in a big firm than a small one. The best firms keep insanely tight controls in place, and they just happen to be the same firms that are holding up fairly well in this tumultuous market.

When the wheels are coming off the market, you've got to know that your vehicle is sturdy. The best firms have reviews of individual trading positions frequently, and at the management committee level. You would think that all CEOs of major firms would do this, but only a few actually do it. The rest of them get fired when it all goes down (Merrill, Citi, Bear).

You have got to MICROMANAGE EVERYTHING when it comes to trading positions.

Break Out The Vaseline

noreply@blogger.com (Keith) — Thu, 17 Jan 2008 17:42:00 +0000

If you woke up on Christmas morning and looked at your portfolio and smiled ... well, you probably aren't smiling now. The market has lost over 10% in the last three weeks, and is down over 8% for the year. That's not good, considering it's only January 17. They've got the market out behind the woodshed right now and are having their way with it.

So what to do? Consumer staples are doing well right now, but nothing else is. When people start getting panicky about their finances, they tend to focus on the basics (food, drinks, cigarettes, guns) and sell off everything else. Yes, guns are a consumer staple to some people. Some financial firms have been getting pummeled for too long and are worth a look. BB&T had little to no exposure to the sub-prime problems, got taken down with the others, but is now starting to stabilize as people realize that the write-downs won't happen there. Same with Goldman Sachs, which doesn't rely on the consumer nearly as much as most other financial firms. Take a look at MO and BUD, stocks that always do well when times appear to be rough. Hey, if you're going down in flames, might as well drink and smoke on the way down.

What are we doing? Well, I can't tell you exactly of course, but I will say that everything we do will be hedged. If we are wrong, we won't be very wrong. If we are right, we will do very well. Sort of what a hedge fund is supposed to do.

Johnson & Johnson (JNJ) is actually up since Christmas Day. Guess who makes Vaseline?

Getting Juicy Out There

noreply@blogger.com (Keith) — Wed, 16 Jan 2008 15:06:00 +0000

With the Dow under 12,500, the S&P under 1400, and the NASDAQ under 2400, things may be looking grim. Unless you have hedges in place, that is. Our market-neutral stance has worked well in this environment. However, our hedges roll off on Friday and we are busy planning the next round of investments. It helps that a bunch of money came in in the last week or so; we have more to put to work.

The Vix is at 24 right now. Since it's that high, there is an opportunity to do very well in the next month or so. We are carefully studying potential ranges on a number of securities before making our final decisions. We will not be short-biased this month; we will either stay perfectly market-neutral or go slightly long in certain areas. That decision isn't going to matter too much in the end, but the decisions on the hedges will.

The S&P is down 6.50% in the first two weeks of the year. So much for January being a good month. I used to try and outperform the S&P by 7% over the course of a year in my old job (and succeeded). We are that far ahead in the first two weeks.

The $18 Billion Writeoff

noreply@blogger.com (Keith) — Tue, 15 Jan 2008 15:54:00 +0000

Sometimes you just have to MICROMANAGE EVERYTHING. Chuck Prince let a few idiots load up several dozen trainfuls of sub-prime loans while he had his back turned, and it came back to bite him hard. $18 billion is a lot of money for one mistake. 10% of the countries on this planet don't have an annual GNP that large. Fewer than twenty guys in the world are worth that much. That's like feeding $574 into a woodchipper, every second, for an entire year. Ok, you get the point. Probably fewer than 50 guys at Citi screwed the other 350,000 employees out of any sort of real bonus in 2007, as well as making their options worthless and their dividend checks a lot smaller.

It's funny how the firms that have aspired to be the financial supermarkets (like Citi, B of A, and Merrill) are the ones who are being hit the hardest. Managing that many pieces of the financial puzzle is tricky during the best of times; being the buyer of last resort for other firms' sewage is sheer stupidity. Hey, I'll hook a hose up to the bottom of my toilet and send whatever comes down the pipe over to those firms too.

There will be a point in time, however, where buying Citi will be a smart investment choice. I've met with Vikram Pandit one-on-one a couple of times back in the 1990s. He is as smart as they come, and he will not allow Citi to make a mistake of this size again. Breaking up the company is the best option for most CEOs. Sandy Weill was able to hold it all together, and Pandit also has that ability, especially as a manager of risk.

But for the moment, Citi needs all the Vaseline you can send them.

Bank of America Buying More Manure

noreply@blogger.com (Keith) — Mon, 14 Jan 2008 16:16:00 +0000

If you put down a $2 bet in poker and then back it up with another $4 on the next betting round, spectators might think you have a good hand. But if you put down $2 billion and then back it up with $4 billion in an attempt to buy the pot, you had better know exactly what you are doing. Countrywide may be a good fit for Bank of America in name only, since the financial behemoth is the country's only true coast-to-coast bank.

The bank has a long, sad history of overpaying for institutions that ultimately deliver less than promised. Over the years, B of A has acquired many firms that were meant to shore up areas in which it was weak. Each time, it succeeded in bringing in more deposits from the customers of those firms, but alienated the core members of the acquiree. As a result, Ken Lewis has been forced to admit over and over that the expected results in the weak areas have not materialized.

Well no kidding, Ken. When you try to force a bank culture down the throat of another industry like investment banking, mortgages, insurance, hedge funds, wealth management, etc, it will never work. The only way to make it work is to let them run things under their own brand, business as usual. When you get bank people out of their element, you wind up with trouble.

Countrywide is a steaming pile of dung fresh from the bowels of the American consumer. It is what is left over from a series of poor decisions on credit (meaning millions of poor decisions, really). There may be a few diamonds in the rough there for B of A to scoop up. But it will get its hands very dirty in the process.

Bloomberg

noreply@blogger.com (Keith) — Thu, 10 Jan 2008 04:32:00 +0000

You might be thinking this is a political post. Not at all - we will be getting our first Bloomberg financial terminal within a month. If you are a financial newbie and don't know what that is, maybe you will understand this analogy. No Bloomberg:Bloomberg::abacus:Cray supercomputer. While it probably won't change our thought process at all, it will save us a great deal of time and effort. At that time we can crank up our strategy into full-throttle mode. We can definitely make money without a Bloomberg, but it is a lot easier and faster to make money with it. Our initial positions are working out well. Normally I don't like to do short-term trades (less than a month), but in this case it absolutely makes sense. Starting off the year up while the market is getting its ass kicked can only help us. Soon we will unleash the power of this fully armed and operational Death Star - wait, bad analogy, the Empire lost in the end. Never mind. Let's just say we are optimistic about our prospects this year.

A random rant: I freak out every morning when I look at our position reports. Even though we are perfectly hedged, I always see a small loss in the mornings. Why? Because options market makers remove their bids/asks after trading ends for the day. So I see things like: Bid = $.05, Ask = $6.70 every morning on the options positions, and of course we are always seeing the worst case when the positions are "marked to market", which in this case is really "marked to insanity". Once trading starts, things brighten up and the true value is reflected and I am happy again. Using the last price of the day is a good idea; using a spread that Evel Knievel couldn't clear on a 600hp Harley is not.

Group Meeting

noreply@blogger.com (Keith) — Mon, 07 Jan 2008 22:56:00 +0000

A quick update - Today we had our first group pow-wow of the new year. We discussed likely trends for 2008 and ate massive amounts of cheeseburgers. The iced tea was flowing as well, all the way through. I know, more detail than you needed. But hey, you will never get anything less than full disclosure from me.

The good news is this - we are on track to have a very good year. The bad news is that not everyone will share our good fortune. Funds that are biased in certain sectors or directions are going to get hammered, unless they see it coming and are able to make some very quick adjustments.

Market Falls Flat On Face

noreply@blogger.com (Keith) — Fri, 04 Jan 2008 21:27:00 +0000

Well, the market has had its worst start to a new calendar year in as long as I can remember. Three trading days into 2008 and the S&P 500 is down nearly 4%. These three days have wiped out ALL of the S&P gains from 2007.

The Fed will certainly cut interest rates this time around, but it probably won't be enough to reverse the market and send it shooting upwards. What the market needs is a real catalyst, and I don't see one lurking around the corner. Many economists are saying that we are probably in a recession, and I agree with them. All indications are that business is slowing down a little bit. That means all of the up and down movements in the market are just noise.

However, that noise helps our strategy a great deal. We are pointing towards an up month so far. What we don't need now is for the S&P to blow through 1400 and head straight for 1300. While our strategy would do fine, it could potentially scare off other investors from the market.

There will come a time when the big financial institutions that have been getting crushed for months will be a slam dunk buy. But there is probably more blood running in the streets before we get to that point

Initial Market Strategy

noreply@blogger.com (Keith) — Thu, 03 Jan 2008 19:07:00 +0000

I mentioned at the beginning of this blog that I wouldn't be going into any detail on individual positions. However, I think it makes a lot of sense to talk in more general terms about the market. We had one of our investment team pow-wows yesterday morning and we agreed unanimously that the market would probably go sideways for a while. I think we are going to see a range of 1400-1550 for the S&P for quite a long time, probably for more than half of 2008.

There is no real catalyst in the near term to move the market out of this range either way. On the downside, the specter of the credit crunch still weighs heavily, as does the likelihood that we are already in an economic recession. Most of that is already priced into stocks in many sectors. On the upside, there are many companies that are growing like gangbusters right now, but their access to capital is tightening more every day. That growth will inevitably slow in a more pronounced fashion because of the aforementioned pressures.

So we are starting out exactly market neutral. We have built the portfolio so that movement in equity prices should have little to know effect on portfolio value. Volatility remains high, however, and we should be able to do very well with our use of options. With portfolio risk essentially removed, the real risk now is simply opportunity cost, which we are more than willing to accept for the time being. The ability to crank out medium-sized (but consistently positive) returns for awhile is not a bad thing.

10 bips a day

noreply@blogger.com (Keith) — Thu, 03 Jan 2008 18:53:00 +0000

That is one of the targets we are shooting for, anyway. Doing that would mean a gross return of about 25%. Naturally, we want to do better. Of course, with a carefully constructed portfolio such as ours, we are just as focused on having low volatility, so a Sharpe ratio in the 2-3 range would be nice.

Apparently, there was another investment group years ago with a name similar to ours. Although they are long gone, they still owe the NYSE some money. How do I know all this? Because the NYSE put a temporary freeze on our ability to trade until they were sure we weren't the same folks. So our initial trades haven't taken place yet. There's always something. At least yesterday we were in cash while the market was down 220 points, so we already look good on a relative basis.

I'm also doing an interview today or tomorrow for an online group; I'll post more on that after it happens.

Admin Really Sucks

noreply@blogger.com (Keith) — Thu, 20 Dec 2007 04:13:00 +0000

I hate admin. With a passion. In fact, I'd like nothing better than to light up the pile of papers on my desk right now with a flamethrower. But I can't. I would destroy months of effort. That's why one of the first things I will do when we have decent cash flow in a few months will be to hire a very strong admin person. Someone who can deal with all of logistical issues while allowing me to focus exclusively on investments. Good admins are worth their weight in gold. A great admin may well be paid their weight in gold if it allows us to be successful. We are going to succeed regardless, but I'd rather succeed quickly by thinking, focusing, and analyzing to the nth degree, than succeed slowly by wallowing in admin hell.

World Class

noreply@blogger.com (Keith) — Wed, 19 Dec 2007 03:25:00 +0000

The distinguished Mr. Galt and I share many similarities in our thinking, but none more important than this: That anything we build together should and must be world class in every aspect. That's not to say that things will start out that way. Our hedge fund will not be launched in the same manner as Eric Mindich's fund. Our first $3 billion will come in a little slower than his did. But we share a vision regarding the final state of the finished product. Everything in between will be the critically important small steps along the way.

These small steps are going to be the hiring of some very bright people. We want them to spend most of their time thinking, not selling or doing admin. They should be wired to create, not to replicate. This organization is going to be very flat by design, with three levels of hierarchy max. Hierarchy is really not the right word anyway, we are going to build a meritocracy, where the rewards and honors will fall upon those who make significant positive contributions.

We are not going to broadcast our grand long term plans right now, or maybe ever. But we will say that the launch of the current fund will be followed by others over the next few years. There will be capital set aside for purely opportunistic situations as well. We will place a high premium on computing power at some point too. When we envision our finished product, it looks something like Citadel or Renaissance in scale and in scope.

We got our first check yesterday, so the pieces are falling into place at just the right time.

Getting Ready

noreply@blogger.com (Keith) — Mon, 17 Dec 2007 16:03:00 +0000

If you've had enough philosophy over the last few days, this post will come as a breath of fresh air.

We are very close to being ready to go live. By the end of today, all of our accounts will be set up and we will be able to receive money. We already have checks coming in through the mail, and wiring instructions for others who want to get funds to us via wire. The trading platform has been loaded onto our computers, and we completed training on that system on Friday. We are "dry trading" until January 2, when we will flip the switch with real money.

Our business cards and letterhead is on its way as well. We are settled into the office now and the phone system and computer systems are all working properly. Our lawyers, accountants, and prime broker are all on the same page.

So in short, we are just about ready to go. We are already planning for all of the meetings and other forms of contact that we plan to have in January. Most people have mentally shut down for the holidays, so we are going to book things now for the next two months. The story is obviously a great one to tell, so we are excited about those prospects. Our strategy works pretty well in just about any market environment, but it really works well in this environment, so we can't wait to get started.

Lemme splain it to ya...

noreply@blogger.com (Keith) — Fri, 14 Dec 2007 23:59:00 +0000

It seems that in the 230+ years since Adam Smith was around, many of our presidential candidates still don't understand that by raising taxes on the high-income earners (entrepreneurs), one provides a huge disincentive for them to not produce like they otherwise would. And when the prime movers don't produce, the ones who pay the most in the end are the folks at the lower end of the income spectrum, the workers, the employees, the less-well-educated, the unskilled, the poor.

So why would certain presidential candidates recommend something that badly hurts those they claim to represent? The honest answer is that they aren't very smart. Even most of the poor employees realize that pain rolls downhill. A business owner who can produce with little friction will hire more employees, pay them more, and be happier. A business owner with an increasingly heavy tax burden will be more likely to lay off people, or cut pay or benefits, or go out of business. All of which hurt the little guy.

In a capitalist society, everyone is better off with a wealth gap between the rich and poor, especially the poor. They have much more opportunity to rise up into the middle class. A society with no wealth gap is the epitome of communism. With no incentive to produce, no one does produce, and you wind up with food lines, starvation, unrest, and probably a dictator. Everyone is worse off.

The key to the wealth of a society is the ability of the prime movers (the top 1%) to produce whatever they are good at. It is the politician's job to recognize the value of the prime movers and stay out of their way. That means keep taxes low for the entrepreneur.

The top 1%

noreply@blogger.com (Keith) — Fri, 14 Dec 2007 04:43:00 +0000

In my experience, the top 1% of the people determine the success or failure of most enterprises. Meaning, if you took away the top 1% of the people out of an endeavor, the entire thing would collapse very quickly into rubble. In a small organization (of say 20 people) you are talking about one person at most who holds the key to greatness or futility. A larger organization with 100,000 people could not withstand the best 1000 people being taken away; it would exist in name only less than one year later if it did not quickly replace its talent. The departure of best 3 million Americans (without replacement) would lead to the rapid demise of this country.

The only exceptions to this rule are organizations that are built specifically for high-octane, super-intelligent people: Google, Goldman Sachs, McKinsey, KKR, Blackstone, and a handful of think tanks. Every one of these organizations believes that the dumbest guy in the room should still be pretty damn smart compared to society.

I bring this up because the biggest challenge our organization will face in the first couple of years will be the ability to attract the best and brightest talent. That is every organization's biggest challenge; it is not unique to us. John Galt and I are determined to surround ourselves with folks who strive to be the best in everything they do. That sounds really cheesy and trite, but if you are around long enough, you start to realize that this is the rarest type of person, and the most coveted. A handful of top people can handle the workload of hundreds, and more importantly, they generate ideas and thoughts that the masses cannot. Those are worth their weight in gold, and they will be rewarded in kind.

Beware of the Behemoth

noreply@blogger.com (Keith) — Wed, 12 Dec 2007 17:35:00 +0000

I was fortunte enough in 2000-2002 to watch with amusement many botched analyst recommendations. One prominent commercial bank put the Buy on EMC at 80, and then rode it down over a period of two years all the way to 3. At that point, they said that the fundamentals had changed, and they put the Sell on. Naturally, EMC slowly came back from that point. Never trust a commercial bank to get investments right.

But here's the scary thing: A big commercial bank is built to make money even when every important decision it makes is wrong. Incompetence in most areas does not mean that you should necessarily short it. Big banks are like out-of-control wrecking balls. Even though the operator may have left the control panel long ago, the ball will keep swinging wildly and knocking things down.

So the decision by Morgan Stanley to make Citi its number one short idea for 2008 is a curious one. Nobody doubts that there is probably more bad news to come out of Citi. Nobody doubts that the leadership of most investment banks and hedge funds could run circles around Citi's management team. Nobody doubts that you could take away 25% of its employees tomorrow and it would still be horribly bloated and inefficient. But to put a short on a major bank after it has already fallen nearly 50% in a few months is dangerous. Especially in a falling interest rate environment, where banks tend to do well.

Professionals lambasted commercial banks in 2002 and 2003 for their horrid mismanagement of investor portfolios. The major financial news sources had nearly an article every day about the wisdom of banks trying to manage money in the face of their own incompetence in this area. Yet, bank stocks rose tremendously during this time, even as they were pilloried in the media. The lesson here is that investment firms are built on brains, and banks are built on redundancies and safeguards. Morgan Stanley would do well to avoid the wrecking ball right now.

These Are the Best of Times

noreply@blogger.com (Keith) — Tue, 11 Dec 2007 14:37:00 +0000

There is one sentiment that we are hearing more frequently these days from friends in the industry. "Aren't you guys trying to launch a hedge fund at a bad time?" After all, money was flowing into emerging hedge funds through July, and now that flow has slowed to a trickle as many investors have fled to bigger, more established names. The sub-prime mess has made people fearful of potential blowups, and their first emotional reaction tends to be panic selling.

Well, we don't have any sub-prime issues here, nor will we, but that is not the point. If you were to ask most investors (accredited investors, fund of funds, large institutions, etc) if they invest rationally or emotionally, nearly all would answer that they invest rationally. In fact, they would pride themselves in their ability to outthink the rest of the market. Yet when the black swan hits the market, they are among the first to retrench. By moving towards the perceived safety of a large entity, they are exhibiting all the wrong tendencies most people want in a money manager ("Even if I'm wrong, everyone else will be wrong too, and I won't look bad in comparison. They can't fire me for being with these bigger guys"). This drives the investment decision far more than anything else. So much for their clients' money. So much for their investment mandate. So much for rational thinking.

We saw this in commercial banks in 2000-2001. They had unexpectedly large inflows of capital as investors fled investment banks during the bear market. The safety that investors sought was merely an illusion; commercial bank portfolios performed terribly during that time, even relative to the market. Investing is outside the core competency of a commercial bank, and millions of investors paid the price.

The truth is that it is a wonderful time to launch. Our strategy is built to work under any conditions, but conditions such as these are ideal and should get us a couple of more points a year versus our long-term expectations. We explain it in very clear, easy-to-understand terminology with an emphasis on how the math works. We only show the worst-case scenarios, never the best case, because it helps people to understand their downside risk. Plus we like to surprise on the upside fairly often. All the hedges we put in place leave a clearly defined range of expected returns that fits well within most people's comfort levels. The lack of leverage and ample diversification are there to add more layers of comfort and safety. Many larger funds do not have these protections in place, so the safety sought in turbulent times can sometimes be elusive. Bigger does not always mean better, and almost never means safer.

Times like these tend to weed out most of the emotional investors anyway, so the investors we attract now will most likely be with us for a very long time. Truth be told, the market desperately needs the emotional investors. The volatility they bring to the party helps us a great deal. But they will not be investors in our funds.

Philosophy Time

noreply@blogger.com (Keith) — Tue, 11 Dec 2007 05:08:00 +0000

You'll get two posts today, because our world headquarters was overwhelmed by admin yesterday. Between the lawyers, the accountants, and the prime broker, we had lots of paper flying. I can't wait to get this part out of the way so we can make clients some money. We probably ought to tell a little more about how we plan to accomplish that...

Our philosophy is that the markets exist where simple math meets human behavior. On one side, you've got a very rational, logical, orderly world (somebody cue Supertramp!) with well-defined rules and a striking absense of exceptions. On the other side, you've got complete chaos, with emotions running wild, people trying to follow a herd, not realizing that they are the herd, and poor decisions being made faster than we can laugh at them. This is our world. We put ourselves squarely at the intersection of rationality and irrationality. It's why we've always made money. If you are where the calm and the storm meet, you can channel and guide the resulting energy into positive returns.

As an simple example, if investors are taking a stock all over the map during volatile times, we can't control where the stock will ultimately wind up. But we can predict with a high degree of accuracy the points it will hit along its wild ride. By setting up bumpers at a select few of those points, we are able to channel a good portion of the return into our clients' pockets. We also set up brick walls just in case we are wrong. This way, our worst case for being 100% wrong isn't very bad, but our best case for being 100% right is very good. If we get it right half the time (or even less than half), we will still collect outsized returns with fairly low risk. So our hedges do an awful lot for us, in protecting investor money and adding to the returns. It's more complex than that of course, but the basic philosophy is surprisingly simple. We just have a bigger tool kit than most other people.

So bring on the chaotic mob and let them run into the orderly math. It's our job to make sure we wrap the math around the mob tightly enough. Sort of like not being able to stop Michael Jordan, but only hoping to contain him. We are the containment experts of the market.

Mortgage 911

noreply@blogger.com (Keith) — Fri, 07 Dec 2007 15:09:00 +0000

If I put a gun to my head and pulled the trigger, I should not expect a reprieve from some higher authority, someone to give me another chance. If I knowingly and purposefully do harm to myself, I am abdicating my right to seek help from my fellow man.

So why on Earth did millions of Americans sign up for a major financial obligation they knew they couldn't meet? Sure, some of them could afford their houses at the time, and then life took a strange turn and they can't afford it now. But most of them fall into a few categories.

1. Dumbass - They just aren't bright enough to comprehend the implications of what they are agreeing to.
2. Keeping up with the Joneses - See #1. The Joneses are smarter than they are and make more money than they do.
3. Life happened - The job was eliminated, the wife has large medical bills now, the two kids are in college now, blah blah blah, etc. When getting a mortgage, you've got to worst-case everything, and plan for disasters. That means leave yourself some serious buffer room.
4. Evil mortgage broker - See #1. The buyers are most likely weak-minded fools who said yes to the first thing that sounded good. They didn't do their homework and now they are stuck.

So here's what I think the government bailout plan should look like:

That's right. Nothing. There shouldn't be a bailout plan. The government does not exist to protect you from your own stupidity. However, Bush and Paulson have joined forces to help over a million homeowners who bought at the top to get out of their mess. Wouldn't it be nice if this hedge fund could get government assistance when we buy securities at the top and then ride them down for over two years? Where's our handout, our free lunch? The government could just undo our bad trades and let us off the hook, right? (HA HA HA, please note extreme sarcasm)

What's going to happen is that the wrangling between banks, the G-men, and homeowners will continue for a while and create more investment opportunities. So while we really don't have a dog in this fight, we will be watching carefully at how this all goes down to take advantage of the blunder. It's sort of like being on the other team when they hand off the football to a fullback who's covered in grease. You know there's going to be a fumble and you've got to put yourself in a position to run it back the other way.

Have a safe and productive weekend!

Don't Frag Yourself ...

noreply@blogger.com (Keith) — Thu, 06 Dec 2007 18:19:00 +0000

...or, How To Take Lemons and Turn Them Into a Large Pitcher of Margaritas.

Watching the flow of money has always fascinated me. It is astonishing how often money flows in predictable directions, even when the situation calls for the polar opposite movement. Whenever there is a crisis in a certain area, there is an inevitable abandonment of that sector and a sudden investment in "safety." But crisis always brings opportunity, if one spends a little time investigating the larger picture. The "safe" investment can vary, but it is almost always not anywhere near where the opportunity is, and often is a poor stand-alone investment. Following the crowd works when you need to go to the bathroom, but rarely is effective during an investment upheaval, because the crowd turns into lemmings and marches straight off a cliff, leaving the rewards to a small band of opportunistic traders who stay behind and sift through the wreckage looking for the opportunities.

Professor Robert Shiller of Yale University is at the forefront of a field of finance called behavioral finance, which examines how human emotions affect the process of making investment decisions. He has done a great deal of work to try to explain why the vast majority of investors will panic and sell at the bottom, or jump in and buy at the peak (after their hair stylist and landscaper have jumped in). 100+ years of market volatility have not changed the behavior of investors one lick; therefore there is something hardwired in many people that lead them to make poor decisions time and time again. The efficient markets hypothesis has as one of its core assumptions that humans are rational beings, and will act rationally in a variety of situations. Nothing could be further from the truth. The human race is lucky to still exist at all, given its abysmal history of rational decision making.

I don't think you can change the behavior of humans, but you sure can model it scientifically. It is possible to make accurate predictions of where money might flow in almost any situation. In the future, you will see us taking advantage of people's innate desire to self-destruct, although we are a few years away from that. Professor Shiller's work is still mostly in the theoretical stage; there are very few hedge funds taking full advantage of human irrationality. That is why there are winners and losers. If every poker player had the same style and same risk tolerance, then no one would make any money in the long run, they would just swap money around in the short term and break even in the long term. Therefore, poker would not exist.

It is important to know that because the vast majority of people get it wrong most of the time, there are investment opportunities created by this behavior alone. What companies are doing is also important, but not as important as knowing where the money will likely flow next. I've stopped wishing that people will behave rationally. We as a species are not capable of it. We don't need to be faster than the proverbial bear to get ahead, just faster than the guy next to us.