A Dash of Insight

Hedge Fund Job Applicant #4

Applicant #4 comes to us with a proposal for portfolio management, balancing risk and reward.  He analyzes the prospect for stocks and compares it to other investment opportunities.

His conclusion is that the recession downside cancels out potential gains in stocks, leaving us with a market that offers no better potential than buying a T-bill.

The overall approach seems intelligent.  Should we sign up this applicant?

Hedge Fund Job Applicant #3

Background

Every job applicant in this series is real, in the sense that the stories are based upon fact.  Some of the applicants are specific people.  Some are based upon someone selling a system through email, telephone, and/or in-person presentations.  All are real.

Applicant #3 is a composite of many options traders over the last twenty years.

The Interview

Applicant #3 shows me trading records covering a three-year period.  During that time, he averaged gains of 18% annually.  He has references from other traders testifying to his skill -- speed, understanding of markets, and the ability to react quickly.  By telephone, admiring traders tell me that the applicant "DID SIZE."  One has to imagine the voice dropping to a deep baritone with extra emphasis.

When I ask the applicant why he is coming to me he explains that he "blew out."  This means that he lost so much in a short period of time that he lost his stake.  Possibly his backers had to make up a deficit.

Many great traders, perhaps most, have had similar experiences.  Those who have not experienced tough times are probably quite rare.  The key question is why and how this happened, and whether it might happen again.

Applicant #3's trading records show that much of the return came from selling option premium, going short both calls and puts on equities.  The strikes were significantly out of the money, and seemed safe against major moves.  For a long time the strategy worked extremely well, with expiring options generating income at each monthly expiration.  If the underlying stocks moved, he "rolled" the short options to a different strike, farther out of the money but increasing the position size.  It would take a move of more than 2 1/2 standard deviations to create a signficant problem.

Should I hire this applicant?  The monthly income is very tempting.

Evaluating Technical Analysis: Hedge Fund Applicant #2

Like anyone who trades, I use technical analysis.  My funds have strategies based upon technical criteria, and my fundamentally-based trades use technical indicators to help with entries and exits.  Any professional looks at charts of holdings and indices all of the time.  I have read many of the leading works on the subject.  As regular readers know, a former professor's style is to read these works in some detail with a lot of notes.  I look at various indicators that seem useful.  Perhaps more on that later, but the point is that I am open-minded and receptive to this approach.

If you did not read earlier posts in this series, please take a look here.  I did not hire applicant #2, nor have I hired any pure technical analyst who has applied.  The problem:

I do not know how to evaluate their work.

I read daily the recommendations of five different technical analysts, and have done so for years.  I like Rev. Shark on TheStreet.com's Real Money site, but part of what I like is his commentary and apparent feel for the current market sentiment.  In a recent "technicals versus fundamentals" debate on the site, something that breaks out in discussions among the participants quite regularly, Rev. Shark insisted that any test had to use a "real"' technical analyst, not just someone who looks at charts.  That would probably be me!  I could not tell you which of the technical analysts I follow have done the best over time.  That would take a lot of tracking, so I have only impressions about what seems to have helped me.

Here is the assessment of Applicant #2:

System

He looks at setups, using his criteria, and gives me specific recommendations.

Characteristics

Frequency of trading:  high
Turnover:  high
Ease of use:  excellent
Risk reward:  difficult to evaluate
Drawdown:  difficult to evaluate

Overall Evaluation

I cannot evaulate the candidate's work because he is showing me a portfolio of past winners.  If he did not have them, he would not be applying.  Even if his record is excellent, I am being "Fooled by Randomness" because the applicants without such a record have moved on to a new occupation.  He might be excellent, but I cannot tell.

I am also bothered by an element of subjectivity.  When a signal has triggered, there is an issue about when to get out of the position.  It makes a big difference.  Partly this is a choice of stops, a topic covered nicely by Brett Steenbarger.  Consistent with his observations, I have found that the choice of stop rules dramatically affects performance, and most stops take you out of good positions.  This seems counter to the prevailing wisdom.

I am also bothered by the applicant reviewing his methods and changing them to find the best 75% of the trades.  This is a constant danger in backtesting.  Has he really learned something, or just improved his fit to past data?

What about the trades he gave me to follow?  What if they work?  Have I learned something meaningful?  Even if I track the his trades for months, I am only seeing one market environment, one part of the cycle, one set of market moods.

How does one determine that a technical analyst adds real value?  I welcome any comments or suggestions on this question.

Hedge Fund Job Interviews: Applicant #2

Applicant #2 approached me on June 8th, 2004.  His method is technical analysis.  He had a daily service for traders some years ago.  After pursuing another venture, he was getting back into this business.  He had improved his methods, he reported, by reviewing his record and only following signals that had a 75% success rate.  He showed me some of his current calls.

For this applicant, I am going to show what he showed me at the time.  Everyone is free to respond to this information, in two ways.  First, should I have hired him right away?  Second, what conclusion should I have made from his calls?

I am going to postpone the decisions I actually made and the rationale until after we all consider what he showed.  Please cover up the latter part of the chart and ask what decision you would have made at the time it was posed.

The first call was Broadcom (BRCM).  The instructions were to watch for the "trigger," a trade at 44, with a target of 50 and risk to 36.  Here is the chart, unadjusted for splits (click to enlarge):

Be sure to cover up the latter part of the chart.

The second call was Qualcom (QCOM).  The instructions were to trigger at 35 (split adjusted this time) with risk to 30.50.

How did I do, or would I have done, depending on whether I took this advice?  What would you have done?

There are a number of issues in hiring technical analysts.  In the next installment we shall look at further submissions from Applicant #2.

If some readers find this too easy, please be patient.  These are typical examples of what hedge fund managers see all of the time.  The key is to develop criteria that allow one to discover what works.  Each applicant raises new questions, and challenges the manager to figure out what works.  The examples will become more complex as we proceed.

If and when this goes into my book, it would probably be better to pose the question without the ability to see the answer!

Hedge Fund Job Interviews: Applicant #1

Applicant #1 is an extreme case.  He has a PhD, a JD, has written nine books and 1200 articles, and has been hired for important positions by the most prestigious Wall Street Firms.  So the paper credentials are excellent!

The price is also right.  He is revealing to me an easy method for investing that would have beaten the S&P by 50% over the last ten years.  First, let's explain that he means that his system would have gotten average gains of 13.4% versus the S&P return of 8.9%.  That is 50% better all right, but people sometimes get confused by these comparisons.

This is a pretty impressive record.  Any applicant that could add that much value is worth his weight in gold.

The System (as described by the applicant)

Here are the four steps you need to follow, once a year:

1. Scan Morningstar's database and pick the top no-load equities in each of the nine "style box" categories, from large-cap growth to small-cap value funds.
2. Invest an equal amount in each of the nine funds.
3. Save regularly, add new money and stay close to your allocations.
4. Then next year scan Morningstar's database again: If the nine funds you already own aren't still near the top, replace them. Otherwise, hang onto your winners.

Characteristics

Frequency of trading -- low
Turnover -- low
Ease of use -- excellent
Risk/Reward -- NA from stats offered
Drawdowns -- NA from stats offered

Evaluation

So we get into the issue of backtesting.  We will see several applicants who use sophisticated backtesting software, and we shall explore the issues involved.

For now, it is simple.  This applicant simply looks at the funds that did well last year in nine different groupings and pretends that he bought them ten years ago.  I have the race results from yesterday's running at Arlington Park available, but they won't let me bet on that race today, drat it!!

Briefly put, this applicant did not do a real backtest -- going back to a given point in time and using the information then available to choose the fund.  The reported results do not show what would have happened by this method.  And, as we will see, this is the most rudimentary form of backtesting, still fraught with peril.

Chasing performance from prior years is how the average investor manages to make half of the market returns over time.  It is sad that people do this, but looking backward is all that most investors know how to do.  They are encouraged to do this by the media and financial reporting.

I choose not to hire applicant #1.  In fact, I bet him a dinner that this strategy underperforms the market for the next year.

Hedge Fund Job Interviews: Introduction

"A Dash" is starting a new series on Hedge Fund Job Interviews.  Everything described has a factual basis in that it depicts an actual approach to our company or a more public solicitation.  Sometimes the applicants do not want full-time work.  Instead they offer a service for a commission.  The problem is the same.  As the one doing the hiring, you must ask whether there is value exceeding the price.

This series should be of broad interest.  Even those hedge fund managers who are not hiring are constantly offerred new trading strategies and systems.  The discussion here will help sort the wheat from the chaff.  Are you asking the right questions?

This series should also interest individual investors.  While you are not hiring employees, your investment in a mutual fund is the equivalent of hiring the fund manager.  Are you asking the right questions?

The top trading firms understand a crucial fact, one that we will take up in more detail.  If you get an applicant who is a successful trader, was he/she (I'm going to do the he/she once, and then for convenience it will be "he") lucky or good?  It is the same problem one confronts when evaluating a new trading system.

There are some resources that explore these questions.  As we conduct our interviews, we shall look to some of the principles described by Bill Rempel.  We hope to add to the list he has developed and also to consider some of his "job applicants."

A very sophisticated approach to these issues is the subject of many posts at Brett Steenbarger's site.  Brett is doing two things simultaneously:

1. Studying and evaluating trading systems; and
2. Evaluating and improving trader performance.

He understands that the two are related, so we look forward to examining and discussing his methods.

Meanwhile, there are two key points to remember in hiring:

1. Everyone sounds good, knows authentic Wall Street Gibberish, and read today's Wall Street Journal.  You won't learn anything from that; and
2. You can't coach speed!!