In the meantime, you should decide, if you like what you are being told by the game facilitators. You should remember the following simple DONTs:
Don’t automatically assume that investing means stock markets, funds and Wall Street.
Don’t fall into the trap that your own capital needs to be working for you at all times, especially on other people's terms.
Don’t fall for theme or trend investing ploys.
Don’t become a gambler yourself, by betting on other gamblers.
Don't buy something for the sake of diversification.
Don't believe stories of safe, stable, and predictable investment income.
PART III
THE DARK SIDE
CHAPTER 7
FORGING THE EDGE
“Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.”
—Sun Tzu
The best strategy for any professional poker player is either to play for really big prize money and prestige (such as taking part in the World Series of Poker) or play amateurs and patsies and make easy money from mistakes and misjudgments by less sophisticated players. There is a famous scene in the movie Rounders (1998) where star poker player Matt Damon sits down at a poker table in Atlantic City aimed at tourists; he knows half of the players at the table by name. However, they all pretend to be amateurs and draw in one unassuming tourist after another. The movie beautifully depicts the happy faces that join the games and the despair when the gullible players with empty pockets. They never knew what hit them.
Imagine the croupier in a large casino at a blackjack table, a person, who with the protection of the casino management, bets on his own position or on the position of one of his gambling clients. He plays this game, backed by house money, day in and out. Not only is he allowed to count cards, but he is actually encouraged to do so; all the while serving cards to customers. He is encouraged to pick out just the best bets with the best possible payouts. In the long term, guess who makes more money—the player or the croupier?
The financial industry is also like this. They have their finger on the pulse of financial markets, and they have the highest incentives to find either inefficiencies or weaknesses in the financial system. Companies have dedicated “prop desks” where “prop trading” takes place. “Prop” is short for proprietary trading—industry jargon for “trading with your own money instead of your clients.” But technically, this is the wrong definition. They always play with other people’s money, as prop traders trade with the funds their shareholders and creditors entrust to them. The easiest way to understand prop desks and proprietary trading is to see them as internal hedge funds—funded, owned and controlled by an investment bank’s top management. How Wall Street institutions turned into giant trading floors, their similarity, and bonds with hedge funds and how they profit from them will be discussed in this chapter.
Hedge Funds—Searcher for Patsies
You might have heard stories about George Soros (credited with “breaking” the Bank of England in 1992) and John Paulson (who profited from the subprime collapse to the tune of $4bn by predicting it and betting that it would happen). They were both hedge fund managers, as were Benjamin Graham and many of his peers and disciples. So what, exactly, is a hedge fund, and what makes it different to all the other pots of money out there?
The term goes back to 1949. Alfred Winslow Jones, a sociologist and former Fortune magazine writer, started an investment pool that he called a “hedged fund.” “When Jones liked a stock, he would borrow money to buy more of it. The leverage increased his profits and risk. To counter the risk, Jones sold short stocks that he felt were overpriced. This was “hedging” the fund’s bets. Jones called the leverage and short-selling “speculative tools used for conservative ends.”32
Today’s hedge funds don't really hedge nor are they considered safe investments. They are simply legal entities that allow for the management of money for other people, without falling under rigid financial regulation mutual funds or other institutional money managers fall under that cater to the “unsophisticated masses.” They can bet money on whatever they like, as long as it is OK with their investors and financial backers. Hedge funds have always been reserved for individuals with lots of money and professional investors—the sophisticated or smart money you might call them.
Hedge funds are usually the most aggressive and most incentivized players on Wall Street. They receive their usual annual management fee in advance ranging from 1% to 2% of the assets they manage, plus a 20% cut from all gains they make in a year. If you consider their business model from a slightly different angle, hedge fund managers are de facto borrowers who use their client’s money as financial leverage, but get paid for it generously. If they lose their clients” money for clients, they are protected by law, as they are usually structured in limited liability companies. Not a bad business model.
However, with this comes all the moral complications that unusual excessive cash payouts have on highly intelligent and less morally inclined players: ranging from excessive risk-taking to very aggressive business practices (just to maximize their own financial payouts). A few are not afraid to challenge central banks, especially when they work together in packs. Some of them are $20 billion in size or bigger, and the largest hedge funds are so big that they deploy several hedge fund strategies at the same time. They can even defy entire nations, like when Elliott Management Corporation (EMC), led by Paul Singer, forced the government of Argentina to negotiate terms for some of its outstanding debt. Singer bought a large number of Argentinian sovereign bonds during that country’s default in 2001—and then refused to let the Argentinian government get away without paying them what was due by the original, pre-default terms of the bonds. To show that EMC means business, EMC went so far as to confiscate an Argentine naval training vessel that lay anchored at the coast of Ghana in October 2012. In March 2016, the Argentinian government, EMC and three more hedge funds agreed to a deal that would end a more than decade-long legal battle.
Hedge funds are designed to make money in every market condition, whether bear or bull, slow or fast. They have models and strategies to profit from any inefficiencies they can detect. Now, you may be wondering what exactly “inefficiency” means. In an investing context, “inefficiency” refers to the failure of people in the market to properly capitalize on the opportunities presented to them. More practically, we're talking about things like overpaying and undervaluing stocks and not understanding the mathematical correlations between them. All situations give rise to the possibility that someone does know the real price profiting. It's in the interest of savvy investors, banks, and hedge funds to have masses of uninformed people in the market, throwing their money around and jumping on any investment fad they can get their hands on.
How these institutions capitalize on such inefficiencies will stagger you. Below, we'll examine three of the most dramatic and effective strategies: the rise of the “quants,” betting in “bots,” and “fat-tail” players.
Ed Thorp and the Rise of the Quants
The story of Edward O. Thorp should be read and studied by any aspiring investor, as it demonstrates the interconnection of professional gambling and speculation that ultimately leads to the logical consequences for intelligent investing. Thorp was one of the pioneers of hedge funds and early representative of Quant hedge funds, a highly mathematical approach to investing. In the early 1970s, Thorp, former math professor, master blackjack player, and retired professional hedge fund manager, got an invitation from actor Paul Newman to discuss a possible investment in his hedge fund Princeton/Newport Partners. Newman had just done The Sting. (The plot involves him teaming up with Robert Redford to con one of the most notorious Chicago gangsters in a horse racing bet.) Thorp had a beer with Newman on the Twentieth Century Fox lot. Newman knew about Thorp’s career as a blackjack player and asked how much Thorp could make at blackjack if he did it full-time. Thorp answer
ed $300,000 a year.
“Why aren’t you out there doing it?” Newman asked.
“Would you do it?” Thorp answered.
Thorp knew from his personal research that Newman must have made about $6 million that year—an amount similar to what he was then earning at his hedge fund. After a serious but friendly discussion, Newman decided not to invest with Princeton-Newport because he felt uncomfortable with the way hedge funds tried to minimize taxes.33
Thorp didn’t really need Newman’s money for his hedge fund, he had other investors in his fund. According to William Poundstone, author of Fortune’s Formula, one investor was a former Warren Buffett client, who invested in the early Buffett Partnerships before it was closed. He had Warren Buffett himself check out Ed Thorp at a personal dinner event at his house in Omaha. They both hit it off and Warren Buffett gave the green light to his friend to invest in Ed Thorp's hedge fund. He wouldn’t regret it.34
Thorp had always been fascinated with numbers and how to make money. He was in search of the perfect money-making formula. With his math skills and extensive research in the field of gambling, he devised a betting strategy that was based on calculating the odds of each bet. He used early computers to run a variety of calculations and simulations for his bankroll, and came up with the optimized blackjack play, which he named his “Basic Strategy.” He wrote the best-selling book, Beat the Dealer, which is still considered the betting bible for all blackjack players. With his rigorous scientific approach, he was a pioneer in this field.
To monetize his new found skill and test it in a real gambling environment, he had the genius idea to sell his betting skills to the highest bidder. He found a prospect in Manny Kimmel, business owner and notorious gambler himself with suspected links to the underworld. Kimmel offered to fund his blackjack bankroll with $100,000, but in return wanted 90% of all profits less expenses.35
Thorp agreed. They tested Thorp’s Blackjack system in Nevada casinos. At first, the casinos he visited didn’t understand why he was consistently winning. Most of them didn’t try to find out. The casino managers simply made it clear that he wasn’t a welcome guest anymore. Thorp knew of stories of similar good players who didn’t heed their warnings. As a result, they got both their arms and legs broken in a special silent room, a room that is usually reserved for monitoring the gambling action on the floor.
Thorp decided to take his business and betting system somewhere else—Wall Street—where failure can mean many things, but never broken bones. It was the right decision. He quickly transformed from blackjack player who could win maximum $300,000 to professional hedge fund manager who, a few years later, made $6 million in fees and capital gains, from a comfortable office in California. He quickly understood that the profit potential was limitless in the hedge fund game.
Thorp applied the same betting strategy and the same money management strategy he perfected in blackjack on financial products. He only traded financial products that his mathematical calculations found to be mispriced by the markets. Early on, he recognized that warrants, (special financial contracts known as derivatives), were mispriced. He found their prices miscalculated and amateurish. He made a fortune for his fund, just trading warrants. When S&P futures were introduced in 1982, he traded S&P futures and made a killing. When junk bonds, were all the rage in the mid-80s, he traded those and made a killing. The explanation for this is simple: Thorp was not a gambler in a classic sense, but he had the discipline to calculate the mathematical odds of each trading idea and bet only on those that were positive. In other words, bets that were the most likely to make a profit.
It was early times on Wall Street for mathematical traders and he was able to cherry pick his bets. As soon as his competition (individual traders, other hedge funds and Wall Street institutions) caught up, Thorp moved on. His logic was simple. The moment conditions changed such that his margins fell and his risk increased (due to competition), he was out.
He noticed that with each new financial product that Wall Street actively promoted to their client, there were enormous inefficiencies. For Thorpe, their sales pitches and professional advice didn’t make much sense, other than giving their clients a new way to gamble their money. But he realized, “when people invest based on useless advice, there may be an opportunity to profit.” He, then, concluded that the more “naive money” was in the market, the easier it was to make money almost risk-free. For him “naive money” came from players without an edge, easy to manipulate, and with lots of money to gamble away. Wall Street nurtured the ideal market players for themselves and people like Thorp.
Bot Traders—Profits every Millisecond
Today, there is the growing group of hedge funds that use sophisticated electronic trading programs to do the trading for them. They recruit mathematicians and physicists from universities like MIT to program their trading software. They trade huge volumes of financial securities every day, and profit from small pricing inefficiencies in the market. They are not so different from traditional quant hedge funds, but they use much more computer processing power and software that trades independently from any human interference. Kenneth Griffin of Citadel is one of the leading players in this field, as is James Simons of Renaissance Technologies. Both earned almost $1.7 billion each in 2015.
Amateur and professional online poker players might have already become acquainted with bot players. Bot players are computer poker players designed to play the game of poker against humans or other computer players. They are commonly referred to as “poker bots.” Computer programmers have implemented complex software, continuously developed and improved to determine the best possible strategy by analyzing the weaknesses and playing patterns of average human players. Instead of attempting to make a computer that plays like a human, they aim to play on their strength of consistency and speed over human players. This leads to strategies that can seem bizarre and are often executed at a blindingly fast rate well beyond the capacity of any human.
Bot traders are the weaponized form of these poker bots. On Wall Street, they are referred to as algo traders (algorithmic) or High-Frequency Traders (HFT). Originally, the rise of electronic trading as opposed to telephone trading, increased liquidity and speed of execution. The lengthy and at times controversial transition from human traders on exchanges to full electronic and automated trading took place between the mid-90th to the early 2000s. Ever since the rise of bot market makers used for trade execution, the electronic revolution has been praised for reducing the trading costs for all involved. However, this is not their only function.
The real revolution of electronic high-speed trading and bot traders took place between 2005 and 2007. Never too tired to make a buck, savvy bot trading hedge fund operators have found a new source of easy money-making. They allowed their bots to trade on their own accounts autonomously without any human interference. Just relying on their complex software, their processing power and sheer speed, they let their bots find the tiniest market inefficiency and place bets in lightning speed before anybody else can. Humans are betting on bot players to gamble better and faster than anyone else. Quite logically, there must be a loser, who is slower and incapable of reacting to fast market changes on the other side. It seems we do still need humans, at least for funding the few winners.
2012 data suggests that Bot trading firms accounted for 50% of all US equity trading volume. HFT firms represent 2% of the approximately 20,000 firms operating today but account for 73% of all equity trading volume.36 The speed of trading and the sheer volume they can process each day has turned them into dominant players on all stock exchanges around the world. Their dominance will only grow with the rise of more sophisticated AI and ever-increasing processing power.
The Fat-Tail Players
Meet Mark Spitznagel, the most famous proponent of a unique Hedge Fund trading strategy and friend and former partner of Nassim Taleb, author of Black Swan and Fooled by Randomness. He is the owner and investment manager of the multi-billion-doll
ar hedge fund management company Universa Investments, L.P. His investment strategy, called “fat-tail trading,” specializes in tail risk. Tail risk is “a form of portfolio risk that arises when the possibility that an investment will move more than three standard deviations from the mean is greater than what is shown by a normal distribution.”37
Don’t worry if that made no sense to you—what it means is you develop a strategy by betting on really unlikely things—for example, being hit by lightning twice in quick succession or a meteor destroying the earth. These are freak accidents to discuss at dinner parties, but they have no relevance in normal daily lives. In almost all cases, that would be the end of it.
In financial markets, the fun has just started. Someone is going to bet on those events occurring or not, and someone is going to bet wrong. Some savvy hedge fund managers told me that it's due to the rear view mirror effect. But then again, in 2007, most people were unwilling to bet on the idea that Lehman Brothers would collapse. Some out there did, and they made a killing.
This is where Spitznagel and his funds come in. He specializes in these type of mispriced bets and makes fortunes in the process. As a result, his fund has a very peculiar return pattern. His performance pattern is almost the exact opposite of the typical mutual fund and index investor’s performance pattern. The usual pattern goes like this: there are several years in a row with stable and expected returns. The average investor feels good and usually brags about his performance for a period—only to be blown out of the water with one miserable crash. Even years of satisfactory performance can be completely wiped out by one severe market correction. Many less experienced investors and traders, numb and baffled, say farewell to public market investing for several years until the next cycle repeats itself. A few hardened investors continue with the pain of falling prices to complete a horrific cycle, all the while paying annual fees for nothing.
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