Sunday, January 27, 2008

From Trader to Hedge Fund

I receive a fair amount of mail from experienced traders who express an interest in affiliating with a hedge fund. It's an understandable desire; there are many benefits to working at a fund. These include access to capital and research, superior trading infrastructure, and (often, but not always) the availability of colleagues for mutual learning and support. Timothy Sykes book An American Hedge Fund is an engaging and interesting account of his development as a trader in the heady late 1990s and his subsequent (and ultimately failed) foray into the hedge fund world.

Before I launch into discussion of Tim's book, let me provide some background for those readers not familiar with hedge funds.

As it happens, few traders end up making the leap to funds, even when they have talent. The reason is that most hedge funds are looking for multifaceted portfolio managers, not directional traders of single asset classes. That is, a portfolio manager (PM) will carry a number of positions in his or her book, many of which are not correlated and some of which may hedge other positions. Compensation for the PM is based on the performance of the portfolio, with a premium placed on risk-adjusted returns (i.e., the fund does not want a PM taking massive risks to make returns, a lesson recently exemplified in the SocGen episode). The portfolio, as a result, has to be diversified, and it has to hedge risk. Such hedging is often accomplished with options, futures, and other derivative instruments, not simply by adding to or taking off of positions.

For this reason, much of the day-to-day work of the PM is managing the portfolio--adjusting hedges, adding to positions at good prices, taking profits at good prices, stopping positions out at preset levels, keeping up to date on news and research affecting the portfolio, scouring for ideas to add to the portfolio; it is not taken up with daytrading. PMs may hold positions for a few days, a few weeks, or many months: much depends on their core strategies and competencies. At a good fund, traders will have expertise across a variety of strategies and markets, which provides the firm with diversification.

You can see why this is challenging for the average trader--even one who has been successful in a proprietary trading environment. At the prop environment, the game tends to be swinging leverage and trading a very limited number of positions at one time for short time frames. Very often the prop trader will trade one asset class only, such as bonds, currencies, or stocks. The trade for the prop trader is usually directional--they're expecting stocks or currencies to rise or fall over the life of the trade. It is not common to see prop and individual traders executing market neutral strategies, such as long/short stock trading; trades that exploit the yield curve; or relative value trades that look for deviations from (and returns to) modeled fair/historical value. It is also uncommon to find hedging strategies among individual and prop traders; quite often, they're either all in or all out and--if not--they're adjusting position size, not hedging with other instruments.

All of this is to say that being a successful trader and being a successful portfolio manager are different skill sets. A trader knows his or her market in depth--particularly at a short time frame--and masters particular strategies or setups. A portfolio manager has to know multiple markets and trade multiple strategies often across multiple time frames. Some of the best daytraders I know would make horrible PMs; and I've never met a PM who understands very short-term market movement as well as the best traders.

So now for An American Hedge Fund. Tim Sykes chronicles his rise as a short-term stock trader during the momentum-driven period of the tech stock boom and then after the market peak. That he was able to succeed in the markets even after the 2000 high is much to his credit; many traders blew up once the momentum game faded (and, ultimately, once volatility itself faded). Tim's book is subtitled, "How I Made $2 Million as a Stock Operator and Created a Hedge Fund". In an well-written narrative, he takes us through this journey.

Tim recounts his individual trades, as well as the lessons learned following (and leading) chat rooms and dealing with boiler room pump-and-dump operations. We learn about the strategies that worked for him--and then that stopped working. Against this backdrop is the growing optimism of a trader who found that college was more useful for its high-speed Internet connection than its courses. I found Sykes' story to be a nostalgic trip back to a unique period of market history; he captures its spirit well.

During the transition to hedge fund, Tim found himself overwhelmed with the paperwork associated with legal filings, documentation of compliance mechanisms, and the like. He had superior returns to show potential investors, but was frustrated by rules limiting hedge fund investment to high net-worth investors. Lacking the strong network of personal and professional contacts that would have come from a background in investment banking, he found it difficult to raise funds.

(Here's where it gets a bit tricky: Even without the SEC regs, Sykes would have found it difficult to raise significant capital. Just as hedge funds seek diversification among traders, very high net worth individuals and institutions--pension funds, etc.--seek diversification among funds. If a fund's returns are highly correlated with the general direction of the stock market, they can be easily replicated at low cost and will not add incremental "alpha" to the investors' returns. In a sense, Tim was not operating a hedge fund; he was continuing his trading under a hedge fund structure. This would not appeal to many money managers.)

As Tim chronicles, his ego got the better of him and led him to take very large short positions that put him in the hole early in his hedge fund career. This would have made it doubly difficult for him to raise funds; a 10%+ blowup over a short time period is not acceptable to investors that seek steady, positive returns. Sykes began his fund with only $1 million in trading capital--a very small amount in hedge fund terms. This by itself would limit the number of positions and strategies that he could employ, particularly after the early loss. After subsequent large losses, he tried returning to his bread-and-butter of trading microcap and high-beta stocks on a short-term basis, which brought some success and a degree of investor interest and participation.

(Here, again, it gets a bit tricky: large investors would not be able to participate in Sykes' fund because they would not perceive his strategies to be "scalable": you can't pour hundreds of millions of dollars into very small stocks without drastically influencing execution and performance. Even with success, his fund would be limited in size simply by this scalability concern.)

Eventually, a heavy loss in a single issue (Cygnus) damaged Tim's profitability and ability to continue raising funds. With media exposure, however, Tim found considerable interest from traders who were drawn to his story. Indeed, it's a valuable, cautionary story for traders, both in terms of the importance of checking ego and risk and from the vantage point of the importance of understanding your industry thoroughly before launching a business.

Tim currently resides in cyberspace at his own personal site, where he tracks his trades in a blog and advocates for changes in SEC regulations regarding funds and their ability to advertise and raise funds. For the record, I do think the time will come when small investors participate in hedge fund returns and strategies, but this will occur through specialty ETFs and further public offerings of stock in large funds--not by making individual funds available to Mom and Pop.

RELEVANT POST:

Joining a Proprietary Trading Firm
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2 comments:

Adam said...

Brett ~

For a couple months I’ve had a ringside seat at the creation and capitalization of a new fund for which my wife is Senior Analyst. I’ve gotten to know the other players. The fund has a go-live date of March 1.

As a moderately successful serial entrepreneur, I find all well-capitalized start-ups by competent practitioners exciting. As a self-taught, at-home, full-time trader I’ve found the birth of a new fund riveting.

I’ve managed to obtain reasonable risk-adjusted returns on my own capital, sums that could support a nice lifestyle. However, deploying around a billion dollars to achieve similar returns presents a different set of complex problems, as your detailed post clearly spells out.

The people setting out to achieve these returns are a different species than even a skilled “amateur.” Okay, I’m flattering myself by using “skilled.” The difference between them and myself is clear: these people are consummate professionals. Moderate self-knowledge tells me the odds of becoming one of them are nil.

It would be foolish, even impossible for an at-home trader to use the diverse species of instruments fund-scale trading requires. Legging into and scaling out of large positions is itself a strategic exercise and has no similarity to going long or short one unit on a signal.

Big, fierce animals are rare. They are separated from the rest of us by a bright paretian line, as Tim Sykes found out. Truth is, I’m often their lunch.

Adam.

Brett Steenbarger, Ph.D. said...

Adam, you are right on the money. Once you begin managing a large sum of money and getting into issues of diversification and portfolio management, trading becomes a very different game--one that many traders are not trained to perform. Thanks for the note--

Brett