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I’m good at shorting, is it possible to start a short biased hedge fund?
I’m good at shorting, is it possible to start a short biased hedge fund? by Laurent Bernut
Answer by Laurent Bernut:
Excellent answer from Bill Chen, to which there is little to add. In my opinion, short-selling is widely misunderstood even by professional sophisticated investors. To add insult to injury, FED and ECB are the official sponsors of the longest bull market on record.
Short-sellers are like sharks…
Did You know that deep in the quiet comfort of your house, there is something 150 times deadlier than a shark ? It is called a bed. The probability of dying after falling out of bed (literally) is 1/2*10^-6, while ex-sanguination from an exploratory shark bite is 1/150*10^-6. Sharks are misunderstood and fragile. So are short sellers.
Adding a short component to a long strategy reduces volatility of performance, increases leverage and reduces drawdowns in terms of magnitude, frequency an period of recovery. Now, this is neither how they are perceived nor marketed.
They are perceived as predatory, nefarious and risky in nature. I lost half of my pension in 2008 to supposedly buy and hold low risk mutual fund #de-friendBuy&Hold.
Short biased funds are relative players, just as your average mutual fund. Their benchmark is just the inverse of the index. When the market goes up by 10% and they clock +8%, effectively they have outperformed. The only problem is that investors lose -8% in absolute. No-one likes to structurally lose money, right ?
Wrong, 3/4 of mutual funds trail their benchmark year in year out. Investors make money in absolute but lose versus index funds. Worse even, mutual funds lose both in absolute and relative during bear markets. So, here is an interesting perception gap:
Short biased funds lose money during bull markets but make some during bear markets. Rationally speaking, they serve a more important purpose than mutual funds. Logically speaking, you do not need a mutual fund, but you do need a short biased fund in order to protect you from downturns.
The problem is that most of them will have died by the time we hit a bear market. The second problem is that short selling is still perceived as evil, when all they do is provide hedge in good times and absolute performance when no-one else does
BTW, small difference of opinion with Mr Chen, redemptions do not come during outperformance during bear phases. They come during early bull markets, when bearish sentiment as well as AUM peak. Short funds handle regime change quite poorly. The same happens with Long Only. Managers can underperform and still grow assets in bull markets because everyone makes money. Long Only underperforming in bear markets is bad…
Prometheus and capitalism
Monetary authorities around the world have mutually decided that bear markets are bad. So, they play god with the markets. They do whatever they can to prop them up. Their latest trick was a sucker punch to the very foundation of capitalism: negative interest rates. In what parallel universe does it make sense for a borrower to be paid to borrow money ?
This begets an interesting question: if they are blind enough to think they can tame the markets, will they be competent enough to solve the problems they have created ?
Anyhow, the point is the only trade in town is: when a tired bull market wants to go down, buy everything and wait for the monetary cavalry to show up with their QE heavy artillery.
This market manipulation is damaging for all market participants. It rewards complacency and bad behavior on the long only side (double down on losers) and wipes out short sellers. In March, i lost -15% in 3 weeks. This bull is tired but central bankers will not admit it until …
What’s the solution then ?
Once upon a time, mortgage bonds were boring. Then, someone figured out a way to package and MARKET them as low risk / high yield investment securities. Shortly thereafter, every other math wiz kid and smooth salesman became fluent in CDO linguo.
Same with short selling. As long as we are the “usual suspects” and default scapegoats for markets falling, speculation, corporate greed, obesity, erectile dysfunctions and all other evils on earth, small or large, then AUM will have wild swings. Picture a young promising executive pitching a short fund during an investment committee Monday morning 9 am
-“ things look a bit dicy here, i would like to start allocating to a short biased fund”, says the newbie
-“sure, buy a dividend fund or allocate more to government bonds funds”, replies the chairman
-”3% dividend is not going to cushion much when the market goes down -50%. Actually, government bonds are the reasons i am getting a bit nervous”, replies the young man
-”Now young man, how do you think our investors will perceive us if they know we are buying a short fund ? They will think we have no confidence in our economy. They will cease to see as patriotic, hard working, disciplined investors, prudent risk managers. They will think of us as short term traders, evil speculators. Rest assured they will redeem”, slams the chairman
-”You are right sir, but our clients will redeem anyway if we lose them money. Short sellers are just as patriotic, hard working and probably more disciplined than Long Only. Short sellers just happen to make money when no-one else around does. At least, if we make money for our clients, we have a chance to keep them. If we are one of the few who make money during downturns, maybe we could even grow assets. Look at Mr Paulson”, whispers the newbie as he shrinks and recoils away
-”You are a bright and talented young man. May i suggest a bit more optimism and team spirit for the rest of your career ?”, concludes the chairman with a paternalistic threat
The reason why John Paulson’s AUM exploded is: he made money when no-one else did. He stood out as a clear winner in a crowd of losers. Short selling is the most important and most valuable skillset. It just has bad press and needs to be repackaged.
Speaking of which, I am writing a book about short selling. 3/4 done already. It is about trading edge: statistical, mental and portfolio construction
I’m good at shorting, is it possible to start a short biased hedge fund?
How significant is following the news for forex trading?
How significant is following the news for forex trading? by Laurent Bernut
Answer by Laurent Bernut:
I know two types of traders: those who trade the newsflow and those who make money. 1) How the brain perceives news 2) What news matters and what does not and how to know which is which 3) Stop Loss and newsflow
- The engineered poison of newsflow: Mice on cocaine, fight flight or freeze
A. Play this game to know how brainwashed You really are
Every day, write down whether you agree with the market comment of the chrematocoulrophone (1) “du jour” on Bloomberg TV. They do a superb feat. When market tanks, they dust off some perma-bear and when markets roof it they fish out some perma-bull. Those financial jesters (1) perfectly rationalise what is happening.
Now, take a piece of paper and write whether 1) you agree with the dude 2) whether he is bull/bear. At the end of the week/month, line up agreement and compare the results with your bullish/bearish view of the world. This is confirmation bias in real time.
B. How the brain perceives news
I want to be the first subscriber to a news channel that reports financial trains arriving on schedule. Currently, financial trains have to either beat their consensus timetable or derail to show up on the news. Until then, Disney Channel is good
News is engineered to elicit reaction: sell paper, trade. It activates the mesolimbic reward circuitry (think mice on cocaine) and/or the stress response: fight, flight or freeze. It is crafted to be sensational. The brain picks up on the noise, the flashes, the tone of voice (try and speak like a newscaster to your friends and see how weird it actually sounds)
The problem with either brain trigger is that it distorts reality. Reward circuitry is dopamine which creates cravings, hence the strong addictive mechanism. This is the euphoria superman drug. Bad news for risk management
The stress response releases a powerfully corrosive drug named cortisol that kills libido, constricts bowel movements, triggers panic attacks and inhibits the pre-frontal cortex, otherwise referred to as the thinking brain. So, Yes, science says that being glued to the newsflow actually makes You dumb. Two ways to prove it: anyone who has been on a trading floor when there some “major news” breaks out knows what i am talking about…
More importantly, when you unplug from the matrix, isn’t your thinking any clearer ? You start to have ideas, think more strategically. The brain fog dissipates. This brain fog comes from staring at the newsflow all day.
Newsflow is literally neurotoxic
2) News that matter, those that don’t and how to spot them
Here is a simple test to assess whether news and more importantly their source have worth following:
- news can reverse a trend: if any news does not have the power to stop and reverse a trend, then it has no market impact
- Persistence: some news cause knee jerk reactions, but then trends resume their course as if nothing happened.
So, in terms of importance, these are the 3 major news that we follow each month
- FOMC: everything in the world is priced of the US 10 year bond. In December, when the Fed raised rates, January was not a happy month…
- BoJ: October 2012, Bank of Japan decides to debase its currency. It did impact not only Japan but the rest of the world
- ECB: has diminishing persistent impact
- Pegs: The Swiss have done a great job at fending off “evil speculators”. Brexit too. We have currency peg alerts on Google, but we stay away from pegged currencies such as HKD, HUF etc anyways
The rest, whether it is non-farm payroll, CPI, PPI, MoM retail numbers, consumer confidence survey, housing starts, inventory or tea leaves expert forecasting, all this rarely elicits anything beyond: “yeah, yeah, pass me the salt, please”. There is immediate market impact, but no trend inversion and no persistence of signal.
Useless does not mean worthless. It means those indicators will be baked in the thought process that will ultimately lead to the decision on rates. They are important components, like the windshield on your car, but what You care about is your automobile, not its parts
3) Stop Loss and news
Beginners want to stay in control. Veterans know control is an illusion. Beginners like to keep a tight leash. Veterans allow markets to breathe. Beginners’ tight stop losses get tripped all the time. Veterans love their long lunches…
Tight stop losses means bigger positions. Combine this with crushing leverage and this is a recipe for a toxic neurococktail: cortisol is a powerful chemical that numbs any pains. It is present in all traders experiencing high stress and in harmful concentration in those who blow-up. Game Over
Forex seems to have more randomness than other data series (at least those i have worked on) on identical sub 30 mn periodicity. I don’t know why and it is irrelevant, frankly. What matters is how the noise gets cancelled in the order management logic.
To that effect, i am the proud inventor of French Stop Loss. We follow a scale-out/scale-in model. Rather than anchoring all stop losses on the latest position’s stop loss, we use the one prior (+ a cute little zest “bien sur”). This gives a lot more wiggle room to positions. Cons: This reduces position size and performance acceleration, Pros: this reduces the number of stop losses, increases win rate, lowers avg loss. Bottom line, this stop loss method is fashionably late, hence French Stop Loss, of course
The point of that digression is that allowing the market to digest knee jerk reactions to news materially increases trading edge
Conclusion
We have three configs for our risk management: autopilot, monetary cavalry and Elvis. Autopilot is our standard config. It is on except for one week every month
Elvis does exactly what it says on the tin: rock n’ roll… Our metric is reproduction rate. Our units are Buffets and absolute. But, damn, those valleys are a seriously bullish signal for the adult diaper industry
More importantly, monetary cavalry is named after the main central banks. The week they come up with some announcement, we tighten risk. This is the only type of news where we take action to reduce risk. Sometimes we end on the profitable side of things, and sometimes we don’t. We have made a conscious decision to earn a little less than we could, because we do not want to lose a lot more than we should, and neither should You
#Quora: How does one address the issue of regime shift in algorithmic trading?
How does one address the issue of regime shift in algorithmic trading? by Laurent Bernut
Answer by Laurent Bernut:
Fascinating topic that has kept me awake for years. It is a thorny issue. As the patent clerk Einstein used to say: answer are not at the same level as questions. Answer is not at the signal (entry/exit) level. These are position sizing and order management issues.
Definition of regime change
Everybody has a savant definition, so i might as well come up with a simple practical metaphor. imagine You drive at 150 km/h on the highway and then all of sudden, this 4 lanes turns into a country road. If You do not react quick, you will go tree-hugging.
There are three market types: bull, bear and more importantly sideways. Each type can be subdivided into quiet or choppy. So, we have six sextants. Regime change is when market moves from one box to another.
It can be either a new volatility regime, or a move from bear to sideways, sideways to bull or vice versa. Markets rarely move from bull to bear. There is some battle between good and evil.
Why it matters?
Many strategies are designed to do well in a particular environment. They make a lot of money that they end up giving back when regime changes. Examples:
- Short Gamma OTM: sell OTM options and collect premium. Pick pennies in front of a steam roller. 2008–2009, August 2015, CHF depeg, Brexit etc. 1 day those options will go in the money and game over
- Dual momentum: trade the shorter time frame but determine regime on longer time frame. When market hits a sideways period, market participants get clobbered on false breakouts like poor cute little baby seals
- Mean reversion: works wonders in sideways markets until it does not. An extreme version of that is Short Gamma
- Value to growth and vice versa: that is probably the most lagging one. By the time, my value colleagues had thrown the towel and loaded up on growthy stocks, market usually gave signs of fatigue…
- Fundamentals pairs trading: relationships are stable until market rotation. For instance, speculative stocks rally hard in the early stage of a bull market, while quality trails. Example: Oct-Dec 2012, Mazda went up +400% while Toyota rallied +30%
The vast majority of market participants are trend followers, whether it is news flow, earning momentum, technical analysis. Trending bulls they do great, trending bears, they can survive. Sideways is where they lose their shirts on false positives.
The issue often boils down to how to enter a sideways regime without losing your shirt
The value of backtests
I agree that backtests will help you identify when your strategy does not work. This is actually the real value of backtest. This is when you modify the strategy and adapt the position sizing to weather unsavoury regimes. Then trade this version, not the ideal fair weather strategy.
Reason is simple: everybody’s got a plan until they get punched in the teeth. So don’t lower your guard, ever.
Asset allocation across multi-strats
Some market participants like to develop specific strategies for specific markets: sideways volatile, awesome for pairs trading, great for options strangle/straddle short. Breakouts are good for trending markets etc.
How do You switch from one to the next ? Fixed asset allocation is as clunky, as primitive and as MPT as it gets. There is something far more elegant and simple:
- Calculate trading edge for each sub-strategy: long Trend Following, pairs etc
- pro-rate trading edge for each strategy
- Allocate by pro-rata
- Allocate a residual minimum even to the negative trading edge strategies
This is a simple way to put money where it works best
Regime change for single strategy
When not to trade
Van Tharp believes that there is no strategy that can do well or at least to weather all market conditions. I believe there is more nuance. Is the objective to make money across all market regimes? For example, sideways quiet are preludes to explosive movements. In order to make any money, you need to trade big and if you are on the wrong side when things kick off, game over
We trade a single unified (mean reversion within trend following) strategy. What follows is our journey through solving the regime change issue. We found that the three best ways to manage regime changes are
- Stop Loss:
- position sizing:
- order management:
Stop Loss
Regime changes are usually accompanied with rise in volatility. Volatility is not risk, volatility is uncertainty #de-friendSharpeRatio
We used to have a complex stop loss rule. Now we have a uniform elegant stop loss. It just lags current position. It is fashionably late, hence its name: French Stop Loss.
The idea there is to give enough breathing room to the markets to absorb changes without giving back too much profit.
Our solution is to consider stop loss as a fail safe and allow the market to switch direction bull to bear and vice versa within the confine of a stop loss.
The result is we end up switching from one regime to the next more fluidly. We have reduced the number of stop losses by 2/3, which in turn has materially increased our expectancy.
Stop losses are costly. They are the maximum you can lose out of any position.So, unless you have a kick ass win rate or extremely long right tail, you want to reduce their frequency and allow the market to transition.
Position sizing
The first thing You need to understand is that You cannot predict/anticipate a regime forecast. You will find out after the facts. This has some immediate consequences on position sizing: always cap your portfolio risk
Many position sizing algorithms use equity in layers or staircase. We base our calculation of peak equity. So, drawdowns however small have an immediate impact on position sizing. This slams the break much faster than any other method i know.
The other side of the equation is risk per trade wich oscillates between min and max risk. When regime becomes favourable again, it accelerates rapidly.
The whole premise is early response to change in regime through position sizing
Another feature is trend maturity. Betting the same -1% at the beginning and at the end of a trend is asking for a serious kick in the money maker. Trends are born, grow, mature, get old and eventually die one day, just like believers in Efficient Market Theory. So, risk less as you pyramid.
Order management and hibernation
Along with the position sizing comes a vastly underrated feature in most order management: trade rejection.
Secondly, we use a position size threshold. When markets get too volatile and we experience some drawdown, stop losses dilate. As a result, position sizes get smaller. When sizes are too small, trades get rejected.
Order management is vastly under-utilised in most systems i have seen. It is often binary, all-in/all-out, or one way scale in or scale out.
In our system, taking profit off the table is a not a function of chart, technical analysis but driven by risk management. Until price goes a certain distance, exits are not triggered. If exits are not triggered, entries cannot be triggered either. Since volatility goes up and position sizes get smaller, the system drops into hibernation.
We have factual evidence that hibernation during an unfavourable regime is a powerful mechanism to weather regime change. It involves a lot more sophistication than muting indicators, slope flattening etc. It encompasses position sizing, order management, stop loss and to a lesser degree signals.
Conclusion
Multi-s
trat asset allocation based on pro-rated trading edge is the easy way to go. Single strat across multiple market regimes means acceleration/deceleration but also hibernation. This is not an easy problem. There is one thought that kept me going through the frustration of figuring this out: “Building a system is like watch making. Time will always be off until the final cog fits in”
How does one address the issue of regime shift in algorithmic trading?