What Do Hedge Funds Really Think?

by: optionMONSTER

Invisigle Hands CoverBy Chris McKhann

We would all love a glimpse into the minds of some of great hedge fund managers, even if their portfolios are much larger and their issues quite different from the ones that we mere mortals will ever have to comprehend. And that is what Steven Drobny gives us in his new book, "The Invisible Hands: Hedge Funds off the Record--Rethinking Real Money."

Drobny's definition of "real money" includes pension funds, endowments, and the like. But so much of what is covered has direct relevance to any trader that this book makes it to the top shelf of my bookcase. I tend to page-tag good books, but for this one I broke out the highlighter as well, something I haven't done since college.

The book is a set of interviews, almost all of them with hedge fund managers speaking with anonymity and extraordinary candor. Even if they aren't handing out the names of individual stocks -- a number of them are global macro players -- the information they are willing to share is valuable to us little guys.

One recommends keeping a trade journal for "hypothesis formation and testing." Another suggests following a "cockroach mandate, which I define as being a survivor no matter what." A third discusses his "hypothetical madness" imagining impossible scenarios that could affect his portfolio.

The most notable consistent theme, especially to me, is the use of options. Virtually all of these managers use options in some way--some for insurance, some for inflation protection, some for limited risk exposure. They use options to help them define risk as well as to reduce the importance of timing the position. Some have option hedges all of the time, while several buy insurance only when it is cheap, paying closer attention to the implied volatilities.

An important focus for all of them is liquidity and correlation--the double-edged sword that really hurts hedge funds and the "real money." Diversification has been shown as the scam it is when the market really tumbles. When correlations go to 1, diversification doesn't matter because everything is falling. (As an aside, I was shocked when some financial adviser had the gall to start talking about diversification on TV the other day. Apparently that lesson hasn't been learned.)

Another interesting part of these discussions was that of their "hit ratios," the percentage of the time that their trades are correct. While many retail traders expect to be right 80 percent of the time or more, these professionals are quick to confess that they are right far less than that: The percentages went from a low of 40 percent up to a high of 65. That leads to the fact that they focus on trades with asymmetrical payouts--in other words, a trade that can risk 5 percent to make 15 or 20 percent.

Other tidbits throughout were emphasized repeatedly throughout the book:

  • Focus on the process, not the payout.
  • You must have the ability to adapt.
  • Don't oversize positions.
  • Avoid big draw-downs.
  • Don't care about being right--care about making money.
  • Never rely just on the models.
  • Survive to trade another day.

This last brings me to one of my favorite quotes, which comes from "Predator":

In order to learn this business, you need to lose a lot of money and survive it.

Just remember that last part is the key.

Disclosure: No positions