Insight from “The Philosopher”

May 22, 2011

Invisible Hands by Steven Drobny is one of the best trading books I’ve read in years. (It was first inhaled a while ago, but the material is so deep it is still sinking in.)

If there is an intellectual heir to the Market Wizards series, Drobny’s two books would be it — first Inside the House of Money, and now this one.

With a dedication that reads “for the taxpayer,” the book was conceived in response to the catastrophic losses endured by pension fund managers in the 2008 meltdown.

Drobny was horrified by the mistakes that pension funds, aka “Real Money,” made with the mountains of taxpayer dollars under their stewardship: The collective retirements of teachers, firemen, cops and the like.

To contribute to the conversation on avoiding future catastrophes, Drobny conducted a series of anonymous interviews with top flight hedge fund managers — the key qualification being, every participant either made money or successfully conserved their capital (avoided drawdown) in 2008.

In other words, these hedgies came through in the worst financial crisis of our time.

The result is quite unlike other offerings: Whereas most great trading books focus on the classic elements — the essentials of trading, if you will — this is more a compendium of nuanced insight and subtle evolutionary ideas.

I saw the book as a sort of research and exploration guide for traders who wish to expand their minds (and their capabilities). There is enough food for thought in Invisible Hands to keep a trader occupied with incremental innovation — tinkering at the margins of one’s process, gradually expanding one’s repertoire — for years to come.

Of the many excellent interviews in Invisible Hands — most all of them anonymous — my favorite was that of “The Philosopher,” a multi-billion-dollar global macro manager.

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Some selected excerpts:

On positive carry and staying in too long:

[Regarding the bond market blowup of 1994:] Perhaps some traders who had been around longer became too obsessed with a positive carry and a belief in their value-driven fundamental models. Ironically, the trades that often make traders lots and lots of money are the very trades that blow them up in the end because they stay in them too long.

On self-awareness, temporary runs, and the importance of market environments:

One of the beautiful things about working on the trading floor is that you are sitting in a big open room with some very good traders. I was always fascinated by how people made money, and I would try to reverse engineer their processes, although my results were often quite different from theirs. Sometimes their self-awareness was lacking, whereby they did not understand that their ability to take money out of a market was in part due to their trading style being conducive to the particular market environment. This is why you often see people have a stellar two- or three-year run, then never make money again. I learned early on from a study of my peers that it is useful to have a variety of styles to be able to adapt to and profit in all types of markets. The biggest macro question is always: “What type of market are we in?” If I know that, then I can implement the style and type of trading that suits that specific market.

On the role of belief in markets:

It is important to note that a key element… is the fact that what other people believe will happen is just as important as the eventual outcome. A market is not a truth mechanism, but rather an interaction of human beings whereby their expectations, beliefs, hopes, and fears shape overall market prices. People in the private equity business can decide if something is a good idea or not held to maturity. My horizon is much shorter term.

On rationalizing versus hypothesizing:

The market is extremely poor at pricing macroeconomics. People always talk about being forward looking, but few actually are. People tell stories to rationalize historical price action more frequently than they use potential future hypotheses to work out where prices could be.

On sentiment and probability mispricing:

Although beliefs tend to be driven by fundamentals, people and markets are very slow to fully incorporate macro information, and when they do the results can be overly dramatic. The uncertain nature of the economic future and our flawed attempts to understand it are a permanent source of market mispricing. The economy is not easily predictable, but the reactions of policy makers and the persistent errors in human expectations are. The natural extension of Keynes’ beauty contest is that animal spirits are not irrational and because they are not irrational they can be anticipated. To illustrate this idea let’s imagine there are two states of the world, and although each is quite reasonable, one is more likely than the other. Unfortunately, the human brain is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Such shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.

On the use of options:

Sometimes I use options, although options are often quite misunderstood. I buy options when they are cheap, not for insurance. Buying insurance when it is too expensive is not a very good way to manage money over the long term. There were times in 2008 when options were ludicrously cheap, making them great things to own. But if you trade primarily in liquid markets, you can truncate the downside through stop losses just as easily as using options.

On the perverse implications of benchmark incentive structures:

What gets you fired? Does losing money get you fired, or does underperforming your benchmark get you fired? If underperforming your benchmark gets you fired, then do not be surprised if people act according to this incentive structure and eventually have a huge absolute return drawdown. The only way to avoid a drawdown catastrophe is to get out early, and getting out early means you have at least some period of underperformance, which can potentially be long. If you do get fired, someone else will be hired to take your place who will chase the benchmark, which is why blowups like 2008 happen. Behavior follows incentive structures, and the incentive structures were strongly weighted towards taking excessive liquidity risk prior to 2008.

On the value of being wrong half the time:

We have a hit ratio of around 50 percent. Although 2008 was a pretty good year, we still had a hit ratio of around 50 percent. It all comes down to trade structure and risk versus reward. If you have a hit ratio of 50 percent and an average payoff of three-to-one, then you make a lot of money. Perhaps surprisingly, I actually find that it is helpful to be wrong half the time. Stopping out of a trade is psychologically much easier when you reserve the right to be wrong half the time.

Trading must be more psychologically challenging for traders who depend on a high hit ratio because at some point we all get it very wrong. They might be consistently right for five years in a row, but then they miss one year and their performance suffers tremendously or they just blow up. I, on the other hand, can have miss after miss after miss, and I am okay because I make sure none of these individual misses can ever sink me.

On global macro vs. bull market strategies:

Global macro is agnostic to market direction; you just want things to happen. Many other investing strategies, however, are essentially bull market strategies, performing better when markets go up and volatility is low and declining. A lot of money has gone into bull market strategies, particularly in the last five or so years, because we have been in a prolonged bull market cycle for the past 20 years. So it is no surprise that many people invest with a bull market style because such a style has been very profitable for a long time. But it is important to remember that many strategies that were relatively successful in the 1960s went bust in the 1970s, with macro persisting successfully through this time. Many people managed money very successfully in the late 1960s, the go-go years. But how many proved profitable through both the 1960s and the 1970s? Most notably, Warren Buffett and George Soros. Although their styles are very different, both are able to take advantage of volatility and both have approaches conducive to that kind of market. Buffett says, “I love Mr. Market because he gives me the opportunity to buy assets when they get too cheap.” And Soros says, “Reflexivity means prices go up and they go down. The world changes and I”ll adapt by reinventing myself over and over again depending on the environment.”

On the myth of diversification:

Diversification is mainly a method for reducing volatility and the confusion comes from the fact that finance professors teach that volatility and risk mean the same thing. Diversification is not an effective method of reducing drawdowns. Moreover, diversification as a strategy can make you complacent, leading you to believe that you have mitigated certain risks that you really have not. You have to ask yourself what you can really diversify, and where. Some risks cannot be diversified away, so unfortunately people tend to ignore them rather than highlight them. For example, it is very difficult to diversify liquidity risk in any way apart from being in liquid products only. But that is not diversification — that just means you are only invested in liquid assets.

On Soros, avoiding drawdowns, and the power of compounding:

The fact that Soros managed to make a lot of money through the bubble and then still made a bit in the crash is brilliant. It is a great way to manage money in the long term. Big drawdowns kill your compound returns, so you have to avoid them.

I want to avoid big drawdowns at all costs. Making the big macro calls when it counts is key, and few can actually do it. It is possible for Soros because the fund is his money. There is no career risk or board to report to. If George is wrong and he winds up being flat while everyone else is up 20 or 30 percent, he will be disappointed, but he cannot be fired, and he did not lose capital. George Soros is successful, and is getting richer still, because he manages money to minimize drawdowns and to maximize compounding over the long term. Compounding is the most powerful force in finance, whereas negative compounding is murderous. A down-50 percent year can take decades to recover from, whereas a series of small up years will compound to great returns over time.

On not becoming a true believer:

You have to be smart enough to make the macro call to get out of the beta-plus assets once you recognize danger in the macro environment, and great money managers have this ability. The trick is making lots of money in bull markets without becoming a true believer. None of the survivors become true believers. Truth exists up to a certain price and you become classified as a true believer once price loses its importance in your thought processes. You have to be conscious of price.

On “black swan” misinterpretation:

“Black swan” may have become the most confusing phrase in markets. Nassim Taleb’s recent use of the term is commonly understood to denote an unlikely and unforeseeable event, but this is not the main story of 2008. I saw a crisis as highly likely given people’s beliefs and behaviors. Many people seem to use the “black swan” idea to reassure themselves when some bad things happened that they did not expect. They use it to claim that it was not their fault, which I do not think was Taleb’s meaning. Too often, people use it to avoid taking responsibility for their actions by claiming the events — and their losses — in 2008 were unforeseeable, whereas in fact their hypothesis of how markets worked was just disproved. The other hypothesis always existed. The metaphor of the black swan is of course an old one and was used by Karl Popper in the 1930s to illustrate the fallacy of induction. It is an example of something that can falsify a hypothesis. If you have a hypothesis that all swans are white, a single black swan falsifies that hypothesis. In this usage, the existence of a black swan is of course neither unforeseeable nor even a low probability event, since hypotheses are falsified all the time. It is as though the recent “black swan” event is not taken as a falsification but instead as confirmation that swans are generally white and so we should carry on as before, which is a perverse interpretation of either Popper or Taleb.

On judging Fed Chairman Bernanke:

Bernanke’s success or error will be decided after the next crash as we find out if it is possible to keep re-inflating bubble after bubble. I am personally pretty skeptical of that idea.

If you enjoyed the above, I hope you feel inspired to read the whole thing.


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9 Responses to Insight from “The Philosopher”

  1. Mubo on May 23, 2011 at 4:32 am

    Long-only guys, stock guys are eagerly awaiting the return of some sort of great moderation/debt-fueled consumption. The truth is that when you look at cross-asset correlations and volatility, we are in another kind of market. This has been accentuated by events of the last 2-3years, but market structures, free capital movement, rise of EM, globalization, etc… make markets even more interlinked. A world where making macro calls is more and more important.

    Thanks for the summary, I liked the Philosopher too, not too keen on the commodities guy in the book though.

    Any idea which manager that might be?

    • Jack Sparrow on May 23, 2011 at 9:31 am

      Which commodity guy, there are three (chapters 8, 9 and 10).

      Your guess is as good as mine… I know the "Plasticine" guy is Hugh Hendry, and "The Equity Trader" sounds a lot like Steve Cohen. Not sure on the others though.

    • Suraj on December 17, 2012 at 9:53 am

      Pretty sure the Philospher is Colm O’Shea (also interviewed in HFMW).

  2. GoodBread on May 23, 2011 at 2:41 pm

    Excellent book. I’m pretty sure Renee Haugerud is one of the commodities’ people and Kent Janer from Nektar is “The House.” I thought his interview was particularly intriguing considering they’re the only shop I can think of that can do relative value fixed-income without blowing themselves up during market dislocations.

    It’s also interesting that a lot of the guys from Inside The House of Money wouldn’t be able to get a spot in Invisible Hands (Siva-Jothy, Thiel, Ospraie, London Diversified…).

    My favorite interviews from the pair are probably Jim Leitner’s. The breadth of things he invests in considering he’s running a family office is pretty amazing and his process seems quite robust.

  3. Dude on May 24, 2011 at 4:31 am

    Yes, Renee Haugerud is the one who who joined Cargill in the book
    Cant remember which chapter it is

  4. Andrés on January 4, 2015 at 3:50 pm

    Yes, “the Philosopher” is Colm O’Shea of Comac Capital. While he killed it in 2008-2009, his fund had two bad years in 2012 and 2013 relative to the global macro space, and went through a lot of redemptions in 2013:

    It would be interesting to try to go back to his chapters in both books (Invisible Hands and HFWM) to see if there’s something in there that could have anticipated this. In my opinion, this passage from his chapter in Invisible Hands is very telling: “What is more difficult is when you have no hypothesis falsification at any thematic level. There are no specific stop losses, yet the overall portfolio is losing money. When that happens, we reduce risk overall,obeying specific triggers we have in place for drawdowns. If I have one of these drawdowns, I have done something wrong and need to reduce risk and reassess.”

    No hypothesis falsification at any thematic level? How about using price as the MAIN and FIRST criteria for falsification rather than waiting for theme falsications (which most of the time come AFTER price confirmation/refutation)? His view on Europe at the time was correct (as we can now judge in hindsight), but his timing was off and price action was showing this at the time, giving him the opportunity to get out of the trade, reasses, and if the thematic idea remained unfalsified THEN think about reentering that trade UNTIL price showed it made sense again from a risk/reward point of view.

    Another thing that jumps for me from that quote is this “…If I have one of these drawdowns, I have done something wrong and need to reduce risk and reassess.” Yet, the WSJ article cites him as saying that “the firm isn’t changing its investment philosophy, risk limits or what markets it trades in.” Well, to me this shows inflexibility as he did in fact have “one of those” drawdowns and is not willing to accept that his risk management was on the loose side. Maybe hedge funds don’t like to confess in the media that they were wrong in order to prevent investors to pull out their money.

    Anyway, I think the main lesson here is that everyone, even the best fund managers, make mistakes; and that price action should always be the MAIN falsification criteria. As PTJ said in the first MW book, “I always believe that prices move first and fundamentals come second.”


    • Jack Sparrow on January 8, 2015 at 4:13 am

      Interesting observations. Thanks for pointing out the WSJ piece.

      Completely agree that price is an excellent guideline. There are so many opportunities, in such a deep ocean of opportunity, that continuing to lose money in situations where price is not confirming seems an unnecessary thing.

      Also, a 5% return since inception seems humbug. I would rather run 10 times less money and go for a CAGR 10x higher, e.g. shoot for a 40-50% CAGR on $300 million. There is a qualitative change when one incorporates the ability to endure controlled drawdowns in pursuit of true outlier returns, especially in macro.

      • Andrés on January 8, 2015 at 9:24 pm

        I agree. However, going for those outlier returns with a smaller size could seem way more labor intensive when you have the option to significantly maximize your management fees, until you realize your overall risk management/trading methodology is not as scalable as you previously thought.

        • Jack Sparrow on January 9, 2015 at 6:48 am

          From my perspective the labor intensive part would be managing unrealistic expectations of artificially restricted volatility. The best way to manage money, more or less, being to trade the way you would if it were 100% your own money, and modifying that general perspective by as small an amount as possible.

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