The following is a book review of Hedge Fund Market Wizards.
I owe Jack Schwager. It was the original "Market Wizards," stumbled across in the mid-1990s, that really opened my eyes to trading.
I had previously discovered "the Investment Biker," by Jim Rogers, and knew I wanted to forego a life in academia and pursue markets. William J. O Neil's "How to Make Money in Stocks" then convinced me to intern at a stock brokerage (Raymond James) my last two college summers.
But it was "Market Wizards," and after that "Methods of a Wall St Master" and "Soros on Soros," that really crystallized the vision.
Unquestionably, "Reminiscences of a Stock Operator" stands alone as the far and away greatest trading book of all time. But the Market Wizards series sits, like a leather-bound canon, just a notch or two below.
Until Steven Drobny's relatively recent "Inside the House of Money" and "Invisible Hands" - sort of the grad school version of Market Wizards, both mind-blowing in their own right - no one had challenged Schwager's run of brilliance and consistency when it came to trader interviews.
Like many others I am sure, I can quote passages from the first three - Market Wizards, New Market Wizards, and Stock Market Wizards - chapter and verse, like a constitutional lawyer referencing supreme court briefings. The books have been absorbed by the trading community so fully that, if you put "MW, NMW or SMW" next to a quote, most serious traders will know exactly what it means.
The series has made its mark not because the traders in Schwager's books are infallible, superhuman, or otherwise worthy of hero worship - no one deserves a pedestal - but because the books are so densely packed with wisdom, ideas and insights that the total net value is mind-boggling. Time and again a market situation, an element of theoretical debate, or an aspect of methodology comes up where one of the Wizards had something clear and sharp to say on the matter.
There were a number of such "a-ha!" insights in HFMW (as I shall abbreviate), though the book felt a little bit lighter than its predecessors. (I will write up my impressions and key takeaways for each HFMW interview separately, as such would take up too much room here.)
The surprising thing, for yours truly at least, was that the most intriguing ideas in HFMW centered around value investing.
One wonders how many trading funds the Market Wizards series is intellectually responsible for seeding - Hundreds? Thousands if one counts the failures? - and now I can say HFMW has given rise to another. Here is the gist:
It struck me, in reading about the value investors in HFMW, that the active and versatile trader could actually have a powerful and hard-to-replicate edge… as a value investor on the side. This would come about through the traders' ability to leave the value investing portion of his funds in cash (or cash equivalents) for significant periods of time.
Let me expound a little…
Kevin Daly, one of the value investors interviewed in HFMW, made an 872 percent return over a 12 year period of time, when the S&P returned negative 9 percent. So Daly must have been good at shorting, right? Nope… Daly did it with very little trading (in terms of managing around positions) and virtually no shorting.
How? By going to cash for extended periods, of long duration, when conditions were unattractive.
This concept - delivering far superior returns by going to cash in adverse periods - dovetails with an interesting theory proposed by Marc Faber in his June 2012 Gloom Boom Doom Report: the notion that long-term investors would do better staying out of markets most of the time, and only investing after a crisis.
From an anecdotal perspective it makes sense too. Imagine if a long-only fund manager had had the good sense to sit in cash all through the 2004-2008 madness… then really loaded the boat at the firesale liquidation values of early 2009, when forced portfolio disgorgement put excellent businesses on sale, lock, stock and barrel, for less than cash in the bank!
The concept also aligns with the methodology of Tom Claugus, another HFMW interviewee, who is only maximum long invested in times of extreme market dislocation (as defined by outlier standard deviations in the S&P), and with the observation of Joel Greenblatt, the final interview in the book, who wryly observes that "value investing works because it doesn't work" for extended periods of time, thus causing the impatient to abandon it.
Sitting in cash - for long-term investors, not active traders! - also seems a natural given the environment we are in, where uncertainty is high and valuations are mediocre-attractive at best. No wonder highly respected value practitioners like Jim Tisch of Loews have been sitting on their hands for years (which they can do as stewards of their own capital).
But of course, it would not be logistically feasible for a standard issue value fund to go dormant, sitting in cash, for months or years at a time. Investors would demand their money back, saying they aren't paying the manager to be idle. And the manager himself would have long stretches of nothing to do.
A sufficiently versatile trading shop COULD implement such a process, however, assuming the shop was 1) skilled and knowledgeable enough to demonstrate deep value capabilities (with a research team devoted to such), and 2) patient enough to leave the long-term investment cash untouched in mediocre to poor allocation conditions.
The ability to actively trade in a SEPARATE fund - where the main activities existed anyway - is what creates this opportunity.
In other words: In conjunction with a trading fund, a deep value fund could be treated as a sort of side pocket (with its own standalone track record). During low-to-no activity periods, the cash balance in the fund could be kept at a minimum.
During periods of excellent opportunity from a long-term perspective, cash could be swept into the value fund, and investors in the more active trading fund could be alerted to the situationally conditional value investing opportunities at hand.
For the first stretch of years, such a fund would likely have to be internal capital only, as telling prospective investors "we might only do something once a year, or sit in cash for 20 months" would not be a great sell. Once an excellent track record developed over time, however - with the power of excellent returns during invested periods overcoming the all-cash periods - investors would see the light and show more willingness to support such a wise and logical approach.
I expand on the concept to give example of the thought processes Schwager has so generously brought forth with this most excellent series. We are almost certainly going to do this when the time is right… so I guess I owe Schwager once again. Thanks Jack!
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.