May 04, 2016

When the Markets Are Volatile, Sometimes the Best Thing to Do Is Nothing

When it’s hard to find a good trade, sometimes the best trade is no trade.

This is the subject of a new book by futures and hedge fund expert Jack Schwager. The title is “Market Wizards” and we sat down with Schwager recently to discuss investment strategy and new disruptive technologies.

Bobby Monks: You have written about “the importance of doing nothing” as a key component of investing successfully. For those unfamiliar with the concept, when conditions are unfavorable or when an investor can’t identify opportunities for a good trade, the best bet is to do nothing. Why do so many investors, including professionals, have trouble adhering to this strategy?

78f1d698-0d48-11e6-9bb2-a9d2e207a807_600x400Jack Schwager: Because doing nothing requires the patience of a saint. It is common for traders who develop good methodologies that signal trades infrequently to take other trades that lack the appropriate criteria because of a need “to do something.”

There is a quote by Debussy that “music is the space between the notes.”

Analogously, one can say that trading success is the trades not taken.

A great example is Kevin Daly, who, when I interviewed him for “Hedge Fund Market Wizards,” had achieved a cumulative gross return of 870% in the 12 years since the inception of his fund in late 1999, a time interim during which the S&P [500] was about breakeven. And even though Daly is an equity hedge fund manager, implying a manager who trades both from the short and long side, shorts were always a very small part of his portfolio, almost invariably a single-digit percentage of the portfolio.

So how does a manager who pursues a near long-only strategy achieve a cumulative return of 870% in a net flat market? The answer is that in the two periods when equity indexes witnessed drawdowns approaching or exceeding 50%, Daly was largely out of the market.

Although Daly’s stock selection contributed to his success, being out of the market when the environment was highly averse to his strategy was the key factor underlying his superior performance. Or, in other words, the trades not taken were more important than the trades taken.

B.M.: What is the biggest mistake that investors make?

J.S.: There are a lot to choose from, but perhaps the most serious and widespread mistake is to confuse future performance with past performance. Just like generals fight the last war, investors invest in the best past performers, a strategy that makes the giant and unjustified assumption that past performance is indicative of future performance.

Why is this a flawed approach? Consider an investor looking for a mutual fund with the best performance during recent years.

Odds are that the best performers will be sector funds in whatever was the hottest sector during that past time frame. But based on research detailed in my book “Market Sense and Nonsense,” on balance, one would actually be better off choosing the worst-performing sectors or strategy categories for hedge funds than the best-performing ones.

Why would this be the case? The explanation is that any sector that has tremendously outperformed in recent years will tend to be overpriced and overinvested.

For example, an investor during the first half of 2014 might well have come up with energy sector funds as a great investment. By that point, however, the boom in oil prices had sown the seeds of its own destruction by spurring increased oil production, increased competition from alternative energy sources and reduced consumption.

Moreover, the very fact that investors flocked into energy funds based on recent past performance meant that the managers of these funds had to deploy the inflow of investor assets into this sector, causing energy stocks to become even more overpriced.

A similar situation exists for the market as a whole. Investors tend to shift increasingly into stocks after the market has performed extremely well for the five or 10 years and shun the market after dismal performance periods.

But the historical record clearly shows that investors would almost invariably do much better by following the exact opposite course.

B.M.: Although you are a legend among professional traders, you are perhaps best known for writing “Market Wizards” and a series of other titles in the series. Your next book, “Undiscovered Market Wizards,” incorporates some unorthodox research to identify today’s market wizards. How are you using FundSeeder in conjunction with the book?

J.S.: FundSeeder Technologies was launched with a primary mission of providing a venue for skilled traders worldwide to be discovered and to have their results verified via daily data transmissions directly from brokers. The underlying motivation for this project was certainly not to help source material for another “Market Wizards” book but rather to disrupt the status quo of the vast majority of investor assets being shepherded by a small number of financial intermediaries into the same small group of large asset managers.

In the current model, a skilled trader without the proper pedigree or connections has virtually no chance of attracting investor assets. In this sense, you could say FundSeeder’s mission is to democratize and globalize the asset management business.

Now, as a side benefit, insofar as FundSeeder is successful in its mission, it would identify previously unknown traders who are worthy of inclusion in a “Market Wizards” book. Also, the potential for such inclusion would in itself serve to attract talented traders to the website, which, in turn, benefits the core mission.

Since I have been getting questions of when “Undiscovered Market Wizards” will be available, I should clarify that the book is neither imminent nor my next book, which will be a 2016 revision of my 1984 book, “A Complete Guide to the Futures Markets.” We have only just launched the new FundSeeder Technologies website, which provides traders with a suite of graphical and analytical tools (some proprietary) and offers direct links to a broader range of brokers.

We have waited till this point before beginning a marketing effort to make traders aware of the Fundseeder website. In fact, this is only the second interview I have done since the site launch.

It will take a couple of years of the new site operating to properly be able to identify candidates for the next “Market Wizards” book, even allowing for the implicit assumption that selected traders will have track records of some length before initiating their FundSeeder accounts.

B.M.: Although you have been critical of mutual funds and, to some extent, leveraged exchange-traded funds, you have been a supporter of hedge fund investing, despite the high fees that may be involved. Why? Would mainstream, non-accredited investors benefit from greater access to hedge funds?

J.S.: First, let me elaborate on my criticism of leveraged ETFs because I think these are dangerous for most investors who don’t understand how they work and not because of the leverage but rather because of the adverse effect of the mathematics of compounding inherent in their structure. I am sure that many investors who buy leveraged ETFs are surprised to discover that they can be right on the market direction and not only fail to enjoy a leveraged return but actually end up with a loss.

This counterintuitive and unpleasant outcome is a combined consequence of the daily rebalancing of ETFs to maintain the same leverage level and the math of compounding. It is impossible to provide a full explanation in a Q&A forum such as this one, but interested readers can find a chapter-length explanation in “Market Sense and Nonsense.”

Regarding hedge funds, I don’t want to be a defender of hedge fund fees. Incidentally, I think the problem here is not so much the magnitude of fees — there is nothing necessarily wrong with 20% or even 25% incentive fees for superior performance, which is not subsequently surrendered — but rather that large incentive fees can be collected and then be followed by losses in following quarters without any offset for the investor.

Theoretically, this problem could be largely solved by a clawback provision for incentive fees or collecting incentive fees with a significant lag (e.g., year), based on the lower of the prior period or current period [net asset value].

The main reason I think multi-manager hedge or [commodity trading adviser] funds can be beneficial to more mainstream investors is that they provide significantly greater diversification than possible with traditional investments only. Although at this point in time, hedge funds have underperformed equity indexes in terms of return, there are two important points to be made in this regard.

First, the current snapshot of time is extremely favorable to equities coming after a very large and sustained bull market. The same comparison made in 2003 or 2009 would have yielded drastically different results.

Second, hedge funds, and particularly hedge funds of funds, generally have far lower volatility than equity indexes, and, in my opinion, return/risk is a far more appropriate performance measure than return.

The article was originally published by The Street.com on April 28th, 2014.