Tuesday, December 23, 2008

Selecting Successful Traders: Implications for Proprietary Trading

In a recent article, Malcolm Gladwell tackled the quarterback problem: the issue of selecting performers who are most likely to succeed in their fields. It turns out that how quarterbacks perform in college is not well correlated with how they perform in the pros, due to the difficulty of the competition at that next level. The same selection challenges, Gladwell notes, affect the selection of teachers; I've also experienced those challenges in working with traders at proprietary trading firms and hedge funds.

One of the great challenges in selecting successful traders is that the usual arsenal of interviews and resume reviews don't begin to tap talents (native abilities) and skills (acquired competencies). As reader Jason pointed out in his comment to my last post, practice and skill-building are necessary but not sufficient; without a base of talents, these at best will take poor performers and bring them closer to average. For instance, although I love the game of basketball and am a competent outside shooter after years of playing, I lack foot speed and jumping ability. I can hold my own in pickup games, but could never star in college--or certainly the pros.

The implications are important: you cannot select for successful traders without observing those traders trade. Just as scouts must see a quarterback play and instructors must observe teachers in the act of teaching, firms that hire traders and portfolio managers need first hand experience with those they would select. To be sure, a trading track record over years of trading and different market conditions can go a long way toward establishing skills and talents. When hiring relatively new traders, however, track records are sparse and may not be representative of trading in the big leagues, with larger risk and size.

Prop firms, as a whole, have found that it is not profitable to hire new traders, offer a dollop of training, and set them loose to figure out markets. Even when the traders are trading very small size, the fees alone for overhead (hardware, software, IT, commissions, etc.) add up and create unacceptable drawdowns before traders can gain traction and make real money. That is why we're seeing an increasing number of firms offer beefed up training, sometimes at a fee, prior to allocating proprietary capital to traders. The training period is an opportunity to observe, first hand, whether traders possess the requisite talents and skills to succeed.

I predict that this trend will continue, with many prop firms increasingly looking like professional training programs over time. Star pupils will gain the right to trade prop capital for the firm, and the training will double as a means of selection. Over time, I further predict that the best of the prop firms will become feeder organizations for hedge funds, as investors burned by buy-and-hold will demand the skill sets that are more typical of traders than portfolio managers. Indeed, if I were a forward thinking hedge fund, I'd look to take a minority financial stake in a superlative prop firm, providing the firm with more capital and resources, and providing the fund with continuous access to a talent pool.

The really good prop firms will trade well. The best, however, will become expert at finding those who trade well.