A Closer Look at the “Mercenary Method”

January 12, 2011
By

It now seems logical to shed a little more light on the “Mercenary Method”…

And by the way, just why are we doing all this?

Because at the end of the day, it’s a winning proposition all around.

While the prodigious amounts of material we share may seem a gift, believe it or not, the greatest gift is to ourselves.

There is no substitute for rigorously clarifying and articulating one’s day to day decision-making processes, and having the incentive to do so via receptive audience of supportive fellow traders.

George Soros attributed hundreds of millions of dollars worth of performance to his Alchemy of Finance public journal experiment, later joking that the true royalties from the project (in the form of trading profits) counted as the highest honorarium a book author has ever received.

In sum, we feel the same way about what we do…

Quant Value Core

The core of the Mercenary Method is captured in our Integrated Macro Analysis (IMA) series. If you haven’t read that yet, we urge you to absorb all three parts. Moving on from that starting point, we can dig in a little more.

One way to describe the bread and butter of what we do is the “quantitative value approach.”

Value quants, as some call them, developed a computerized process for going long value and short growth, based on the proven observation that value consistently outperforms growth over extended periods time. Beginning in the late 1990s, perhaps the most famous and successful of these was Cliff Asness of AQR capital.

To clarify, we do not claim to be full-blown quants by any stretch of the imagination. We are not nearly computerized enough for that. In our flexibility, we are also happy to buy “growth” – and we can even buy “garbage,” just for a trade, under exactly the right conditions.

But the concept of a long side bias towards high quality, strong cash flow, attractively or reasonably valued names – juxtaposed with a short bias against overhyped, overvalued, overextended growth names driven by inflated expectations – is a fair description of our general long / short orientation.

By and large we agree with Bernard Baruch’s view that “Bears can only make money if the bulls push up stocks to where they are overpriced and unsound.” Couple that with a willingness to own quality names showing positive momentum and there you have it.

“Best in Class” Balance

From this starting point, and using the principles of horizontal & vertical exposure, we then proceed to find absolute longs and shorts within the context of a balanced portfolio.

By “absolute” we mean that, for an idea to go in the portfolio long or short, it must stand on its own merits in terms of fundamentals, technicals, and sentiment. Nothing is chosen for hedging purposes only.

Operationally speaking, on a day to day basis we regularly hunt for what our friend and colleague Peter Brandt calls “best in class” chart formations. First we use a combination of top down and bottom up analysis (i.e. the market tower)  to identify various industry groups and themes that look attractive from either a bullish or bearish perspective.

Then we closely monitor this dynamic universe of names via data screens, visual scans, and automated signaling tools to find new long and short setups day in and day out.

Last but not least – very important actually – we regularly monitor net exposure levels and make decisions as to new longs and shorts based on the total composition of the portfolio.

In other words, new positions are not added in a vacuum. They are considered in the context of what we already have on, what our current net exposure levels are, what current profit levels are, and so on.

And of course, we also maintain an ability to use macro-level instruments (such as ETFs, forex and futures) to express opinions on broad sweeping top down themes as well.

The regular operation of the Mercenary portfolio has a “quant” feel in that, like the quant value guys, we have the ability to manage a significant number of positions (sometimes 20 or more). We can do this via the implementation of automated position management rules – not fully automated, but to enough of a degree that a large number of positions can be handled without issue. (We’ll explain these rules in more detail in the upcoming MT Driver’s Manual.)

An area where we significantly differ from the quants, though, is in our discretionary ability to manipulate net exposure levels as we see fit — sometimes dramatically so.

For example, a fully computerized quant value fund might have a mandate to maintain 20% net long exposure at all times, and only adjust that ratio on a monthly or quarterly basis. We are much more flexible and discretionary, in that our net exposure levels can run the gamut from 200% long, to 200% short, to perfectly balanced or anywhere in between. We feel this flexibility gives us an edge, and seasoned intuition plays a key role in utilizing it.

(As George Goodman’s money manager mentor expressed in classic southern drawl: “A good dawg is wonnerful for huntin’, can’t do without him, but you doan give the gun to the dawg.”)

Negative Carry Optionality

Another way we differ is in our ability to implement what we call “negative carry trades.”

A negative carry trade is one in which risk is limited, but you pay a cost to keep the position on – typically in the form of time erosion, as with the purchase of long-dated puts or credit default swaps.

The most spectacular gains of recent years were all driven by negative carry trades.

  • When John Paulson made billions on the subprime meltdown, he did so through a negative carry trade – one where risk was limited, but holding the position bore a measurable cost over a defined timeframe.
  • When Corriente Capital and others made hundreds of millions (if not more) on the European debt crisis, they did so through negative carry trades that paid off huge when the anticipated events occurred.
  • Hugh Hendry, manager of the Eclectica funds, has expressed his bearishness on China and Japan through negative carry trades with the potential to pay off spectacularly within the next two years, and so on.

Some hedge funds actually set up special segregated accounts, specifically to implement negative carry trades oriented to a big macro level idea.

“If China blows up in the next 24 years, you could see a 500% total return on your investment. If it doesn’t, our defined downside risk is 18% per year,” and so on.

We are a little different. Negative carry trades are not our bread and butter, but we do have the willingness to implement them, on an opportunistic basis, after our bread and butter methodology has produced the accumulated profit reserves to justify doing so.

So, for example: Let us say that, hypothetically, nine months into the trading year we are up 16% (or 1600 basis points). Then further say we have a very high level of conviction that, for a combination of reasons, a major market dislocation could occur in the final three months of the year.

Given our flexibility, this scenario might allow us to take, say, 400 basis points (4%) of our accumulated annual profit and invest it in a negative carry trade – a structured options position with defined downside risk – that plays out over a 12 week time frame.

If we are right as to our fourth quarter convictions, the negative carry trade could then offer the potential of a 7 to 1 return (as gains on positions like these are very high), creating the opportunity to score a +40% year without placing excessive capital at risk.

We particularly favor negative carry optionality because we are simultaneously risk-savvy and risk-averse. To us the ideal profile is one in which you first cut off the left side of the distribution (i.e. losing money) as swiftly and cleanly as possible.

Then, once a cushion of profits has been accrued, you pursue reward to risk profiles that allow for the possibility of turning a solid year into a fantastic year, without  excessive capital loss (profit giveback) if your convictions do not pan out.

Through our bread and butter method of seeking out “best in class” long / short opportunities, consistently adjusting for balance and net exposure levels, and with the ability to express macro level convictions through profit-funded negative carry trades, we feel we can compete with the best in the world at this game.

And this entire process, complete with thought processes, daily trade setups, and real trade executions in real time, is shared with Mercenary community members via the Live Feed.

Not Magic, But Process

Of course, all forms of trading and investing involve risk of loss, and past performance is no guarantee of future results.

And yet, for those skeptical of the possibility of earning 30-40% annual returns with an asymmetric volatility profile – deliberate volatility on the upside, sharply limited volatility on the downside – may we remind you of the legendary Stan Druckenmiller’s 30% returns over 30 years (with no losing years).

That type of performance does not grow on trees, but a meaningful universe of traders has produced it… some with even higher compound annual returns than 30%, born of a willingness to take on more calculated risk (and endure the occasional annual loss).

The great science fiction writer Arthur C. Clarke once observed that “Any sufficiently advanced technology is indistinguishable from magic.”

We do not believe in magic, but we do believe in complex emergent phenomena and the ability of a finely tuned whole to be much more than the sum of its parts.

And as far as ingenuity, creativity, and the power of prudently applied leverage in achieving “magical” results are concerned, the following youtube clip shows what a truly motivated individual can do:

JS

p.s. Like this article? For more, visit our Knowledge Center!

p.p.s. If you haven't already, check out the Strategic Intelligence Report!




Similar articles you might like:

Like this article? Share!

Leave a Reply

Your email address will not be published.