Stock Market Wizards

by Jack D. Schwager

  You’re absolutely right. The strong bull trend in the stock market during the late 1990s bailed out a lot of people who were basically just long traders. During those years, if you held a position that went against you, it would eventually come back. I try to teach people not to have any preconceived notion about the market direction—to react to the market, not to anticipate it.

  One hedge group that I worked with would wait for a trade to set up before taking a long position. If it didn’t set up, they wouldn’t do anything. So they were either long or on the sidelines. I finally got them to change, so that when conditions were unfavorable for a long position, they would go short instead of staying neutral. It worked, and they made a lot of money, but they couldn’t stand being short. In their minds, the market went down, so it must be a buying opportunity. Well, guess what—they reversed to long, and the market just kept on going down. Even their language reflected their bias. When they referred to the market decline, they used the word “correction,” not “downtrend.” It never occurred to them that we might actually be in a bear market.

  Has the bear market affected your trading at all?

  Not at all; as long as I have volatility, I’m fine. A true trader can make money in any environment as long as he reacts and doesn’t anticipate. He must feel the markets flow and never fight. He may often be wrong, but never inflexible.

  * * *

  ALPHONSE “BUDDY” FLETCHER JR.

  Win-Win Investing

  Every investment expert knows that you can’t achieve high returns, say an average of 40 or 50 percent per year, without taking on significant risk. Apparently, no one ever bothered to explain this basic concept to Alphonse Fletcher Jr. Otherwise he would have known better than to try to generate consistent high returns, with hardly any losing months, as he has done since placing his first trade thirteen years ago.

  Fletcher began his financial career at Bear Stearns as a researcher and trader of the firm’s own funds. After two very successful years, he was lured away to a similar position at Kidder Peabody. * Although he loved working at Bear Stearns and was very reluctant to leave, Kidder’s job offer was just too lucrative to turn down. In addition to his salary, Kidder promised Fletcher a 20 to 25 percent bonus on his trading profits.

  In his first year at Kidder, Fletcher made over $25 million for the firm. Instead of the $5-million-plus bonus he had anticipated, however, Kidder paid him $1.7 million, with a promise to make additional deferred payments over the next few years. When Fletcher protested that the company was reneging on its deal with him, he was told he shouldn’t complain because he was “one of the highest paid black males” in the country. One company officer is alleged to have commented that the bonus Kidder was obligated to pay Fletcher was “simply too much money to pay a young black man.” These quotes were taken from the court transcripts in the suit that Fletcher brought against his former employer with other specifics derived from published articles; Fletcher himself was very reluctant to discuss the details of the episode. Fletcher was ultimately awarded an additional $1.26 million by an arbitration panel. After leaving Kidder, Fletcher founded his own firm, Fletcher Asset Management.

  I visited Fletcher on one of those brutally hot, humid New York City summer afternoons. I always prefer to walk in cities whenever possible as opposed to taking taxis or public transportation. But I was running a bit late for my scheduled interview with Fletcher, so I hopped a cab. The midtown traffic was horrendous. After going two short blocks in five minutes, about one-third of my normal walking pace, I handed the driver a $5 bill and jumped out, still a mile and a half from my destination.

  By the time I arrived at Fletcher Asset Management, I must have looked as if I had walked through a shower. The offices are located in a 120-year-old limestone townhouse on the Upper East Side. I stepped through the large, heavy wooden door, moving from the heat and noise of the modern city into a cool, quiet, and elegant interior. The entranceway led to a large circular reception area with soaring ceilings and a hand-crafted spiral wooden staircase that rose to the offices on the four upper floors. The walls were painted in warm, rich complementary colors, which when combined with the lofty ceilings, wide ornamental moldings, and antique furniture created an atmosphere of a different time and place, far removed from New York City circa 1999. If I were filming a movie with a scene at an old-line Swiss investment firm catering to clients with tens or hundreds of millions of dollars, this would be the perfect set.

  I was led into a library that served as a waiting room and was offered a large pitcher of ice water, which I rapidly gulped down as soon as the attendant left the room. After about ten minutes, I was escorted up the staircase to Fletcher’s office.

  It is clear that Fletcher has deliberately created an environment that is in striking contrast to the typical modern Manhattan office. The result is very effective in creating a tranquil sanctuary from the frenzy of the city outside, with a sense of style that must send a subliminal message to investors: your money will be safe here.

  Fletcher, however, doesn’t need impressive offices to attract investors. His performance results almost defy belief. That is not to say that he has the highest returns around—not by a long shot. However, those who look only at returns suffer from extreme naïveté. It is not return that matters, but rather return relative to risk. Here Fletcher shines. The Fletcher Fund, his flagship fund, founded in September 1995, has realized an average annual compounded return of 47 percent. Although this is quite impressive on its own, here is the kicker: He has achieved this return with only four losing months, the largest of these being a minuscule 1.5 percent decline.

  Fletcher’s track record prior to launching his fund is, if anything, even more astounding. During the first four years of its existence, Fletcher’s firm, which was founded in 1991, primarily traded its own proprietary account. This account, which was traded at much higher leverage than his fund, garnered an incredible average annual compounded return of 380 percent during that period. (Although returns in these earlier years are not published or reported in any way because they represent a proprietary account, the figures have been audited.)

  When I first saw Fletcher’s track record, I couldn’t conceive how he could achieve such a substantial return with virtually no risk. In our meeting, he explained exactly how he does it. Yes, in reading this chapter, you will find out as well. However, so as not to create false expectations, I will tell you at the outset that his methods are not duplicable by ordinary investors. Even so, why would he reveal what he does? The answer is explained in the interview.

  * * *

  When did you first develop an interest in the markets?

  It probably started when I was in junior high school and my father and I worked on developing a computer program to pick winners at the dog racetrack. [He laughs robustly at the memory.]

  Did you have any success trying to forecast dog races?

  Oh yes. The computer would eliminate one set of races it couldn’t predict. In the remaining races, the program had an 80 percent accuracy rate in picking a dog that would place in the money [win, place, or show].

  That’s pretty impressive. How much money did you make?

  I learned an interesting lesson about odds: winning 80 percent of the time may not be enough if the odds are not right. I forget the exact number, but the track takes about 40 percent or more off the table.

  Wow, that’s incredible—that even makes slot machines look good!

  So even though we won 80 percent of the time, it still wasn’t enough to make any money.

  What information were you using to predict the race outcome?

  All the information that comes in the racing program—finish times for the dogs in different races, positions at different poles, weather conditions, etc.

  How did you try to solve this problem? Did you use multiple regression?

  Hey, remember I was only in junior high.

  When did you actually get involved with stocks?

&nb
sp; When I was in college, I had a summer job with Pfizer, and they had an employee program that allowed you to buy stock in the company for a 25 percent discount. That sounded like a great deal to me. Ironically, as we fast-forward to the present, both of these principles—the computerized analysis of odds and buying stock at a discount—are hallmarks of what we do today. Of course, I don’t mean this literally, since we don’t buy stocks at a discount, and we don’t make bets on who’s going to be the winner. Nevertheless, those concepts tie into our current strategies in a remarkable way.

  Let’s go back to your origins. How did you actually get involved in trading the market?

  I graduated Harvard with a math degree. At the time, everyone was going into M.B.A. programs or Wall Street.

  As a math major at Harvard, I assume that you must have had phenomenal SAT scores.

  Let’s just say that I did very well. The funny thing is that I didn’t take any of the SAT preparatory courses. I prefer to figure out things for myself rather than learn the tricks of the trade. I’m still like that today.

  Sometimes I play word or math games for fun.

  For example.

  This is my latest thing. [He picks up an abacus. ] I have no interest in reading instructions on how to use it, but I am intrigued by the idea of trying to figure it out for myself. I want to work out what algorithm you would use to do addition, subtraction, multiplication, and division on this instrument.

  Did you plan to go to Wall Street when you finished college?

  No, actually I planned to go into the air force

  Why the air force?

  I had been in air force ROTC in college, and the idea of becoming a weapons officer and being responsible for all the new high-tech equipment appealed to me.

  Did you join the air force?

  No. In the late 1980s, there were significant cuts in the defense budget. In order to reduce the number of personnel, the air force encouraged us to go into the reserves. A good friend convinced me to look for a job on Wall Street. I was offered a position at Bear Stearns and fell in love with the place. They in turn virtually adopted me. I don’t know what the magic was, but Elliot Wolk, who was a member of the board of directors and the head of the options department, took a liking to me.

  Were any of your courses at Harvard helpful in preparing you for the real world?

  In my senior year, I took a graduate-level course in financial engineering. I did my project on the options market and found it fascinating. I tried to model what would happen if an option price was forced away from its theoretical value, say because someone placed a large buy or sell order that moved the market. My results convinced me that I had found a way to consistently capture profits in the options market. The idea that I could develop a model that would consistently make money in options, however, went against all the theory I had learned about the markets.

  From that comment I take it that, at the time, you believed in the efficient market hypothesis, as it was taught at Harvard.

  Yes indeed [he laughs loudly]. In many respects, I still believe it, but as you’ll see, there is an interesting other side.

  You believe it—in what sense? After all, your own performance seems to belie the theory that markets are perfectly efficient.

  If IBM is trading at $100 right now, it’s probably worth $100. I think it is very difficult to outsmart liquid markets.

  You mean by using a methodology that depends on getting the future price direction right?

  That’s correct.

  So where doesn’t the efficient market hypothesis apply—say in your own case?

  My analysis implied that it was possible to implement offsetting trades, in which the total position had little or no risk and still provided a profit opportunity. In the real world, such discrepancies might occasionally occur because a large buy or sell order might knock a specific option or security out of whack with the rest of the market. In a theoretical model, however, it should be impossible to show a consistent risk-free opportunity if the efficient market hypothesis is correct. As it turned out, my model was right. In fact, it was the basis for the very first trade I did for Bear Stearns, and it was very lucrative for them.

  What was this virtually risk-free market opportunity that you say was consistently available?

  The concept was based on the cost of financing. Sure IBM is worth whatever it’s trading at. However, let’s say that I can earn 7 percent on my money, and you can earn 9 percent on your money. Given the assumption of our having different rates of return on our money, I should be able to buy IBM and sell it to you at a future date for some agreed price, and we would both be better off. For example, I might buy IBM at $100 and agree to sell it to you for $108 one year from now. I would make more than my 7 percent assumed alternative rate of return, and you would lock in ownership of IBM at less than your assumed opportunity cost of 9 percent annualized. The transaction would be mutually beneficial.

  Wouldn’t arbitrage drive that opportunity away?

  Arbitrage will only eliminate opportunities where we both have the same costs of funds. If, however, your cost of funds is significantly higher or lower, then there will be an opportunity. In a more general sense, the markets might be priced very efficiently if everyone had the same costs of funds, received the same dividend, and had the same transaction costs. If, however, one set of investors is treated very differently, and persistently treated differently, then it should be possible to set up a transaction that offers a consistent profit opportunity.

  Give me a specific example.

  Instead of IBM, say we’re talking about an Italian computer company. Assume that because of tax withholding, U.S. investors receive only 70 cents on the dollar in dividends, whereas Italian investors receive the full dollar. If this is the case, a consistent arbitrage becomes available, wherein a U.S. investor could sell the stock to an Italian investor, establish a hedge, and after the dividend has been paid, buy it back at terms that would be beneficial to both parties.

  It almost sounds as if you are performing a service. If I understand you correctly, you find buyers and sellers who have different costs or returns, due to a distortion, such as differences in tax treatment. You then devise a transaction based on this difference in which each party ends up better off, and you lock in a profit for performing the transaction.

  Exactly. The key word you used was service. That’s one of the key reasons why the results we have delivered are so different from those of traditional investment managers, who buy and sell and then hope for the best.

  How could you ever lose in that type of transaction?

  Very easily. It is very important that there is a real economic trade in which the Italian investor actually buys the shares and is the holder of those shares at the time of the dividend payment. If that’s the case, then there are real transactions, with real exposure to economic gains and losses, and something can go wrong. For example, if there is an adverse price movement after the trade and before we can fully implement the hedge, then we could lose money.

  The trading opportunity based on the option model you developed in college, however, was obviously different, since it only involved U.S. markets. What was the idea behind that strategy?

  In my model, I was using two different interest rates. I found that assumption led to a consistent profit opportunity.

  Why were you using two different interest rates?

  I used the risk-free interest rate [T-bill rate] to generate theoretical option values, and I used a commercial interest rate to reflect the perspective of an option buyer who had a cost of borrowing funds that was greater than the risk-free rate. As a consequence of using two different rates, trading opportunities appeared.

  What precisely was the anomaly you found?

  The market was pricing options based on a theoretical model that assumed a risk-free rate. For most investors, however, the relevant interest rate was the cost of borrowing, which was higher. For example, the option-pricing model might ass
ume a 7 percent interest rate while the investor might have an 8 percent cost of borrowing. This discrepancy implied a profit opportunity.

  What was the trading strategy implied by this anomaly?

  An option box spread.

  [If you are one of the few readers who understands this, congratulations. If, however, you think an option box spread is a quilt design, a sexual position, or some other equally accurate conjecture, don’t worry about it. Any explanation I might attempt would only serve to confuse you further. Take my word for it. For the purpose of what follows, it is sufficient to know that an option box spread is a trade that involves the simultaneous implementation of four separate option positions.]

  Given the substantial transaction costs (commissions plus bid/ask differentials), is this trade applicable in the real world?

  You’re quite right. Normally, the interest rate differences are not sufficiently wide to offer any consistent opportunity once trading costs are taken into account. The key point, however, is that there are exceptions, and it is these exceptions that provide the profit opportunity. For example, a corporation that has a large capital loss would have to pay the full tax rate on interest income, but would not have any tax obligation if they earned the equivalent income in an option trade [because the capital gain on the option trade would be offset by their existing capital loss]. Assume their short-term interest rate is 8 percent and they can implement an option box spread at levels that imply the same 8 percent return. Although it is the same return, the corporation would be much better off because the return is a capital gain instead of interest income. To them, the return would look more like 11 percent.

  Where do you get your income on the trade?

  Initially, we made money either by implementing the transaction for the corporation and charging a commission, or by taking the other side of the trade. The difference in the tax treatment of different parties is what creates the profit opportunity. I would add that although the examples I have given you used illustrations in which the economic profits were enhanced by tax benefits, most of our trades are not tax-related.