Tuesday, December 18, 2012

Asset Allocation 101


There is no single answer to asset allocation, and it is every man for himself. One thing that I can tell you with certainty is how a hedge fund approaches the issue.

The biggest hedge funds run thousands of positions across countries, industries, sectors, and currencies that are dynamically hedged on a real time basis. To monitor this they need a global 24-hour multilingual trading desk backed by the latest mainframe computers using custom designed, cutting edge software. They have gobs of bandwidth too, as a nanosecond can make the difference between winning and losing on a trade. You can put together something like this for, oh, maybe $100 million, give or take a few dozen million. It’s all enough to send an MIT math PhD’s head spinning.

I’ll draw up a strategy that might fit a small, one-man hedge fund, with limited resources and programming abilities on a tight budget that is managing only $100,000. In other words, it will be for somebody a lot like you.

 

What Did You Say the Difference Between a Bid and an Offer Was? 

1) How Many Positions Can I Realistically Follow? I’d start out small, maybe with five. That means that you can allocate $20,000 to each on five positions. If you get comfortable with this, you can increase to 10 positions of $10,000 each later on, as I do in my model trading portfolio. Keep in mind that the more positions, the more work it takes to track it. You never want to have so many positions that you can’t follow what is going on.

Tracking Your Portfolio is Easier Said Than Done 

2) Show Me the Money. Global macro hedge funds, like the one I run, have no hard and fast rules for where to allocate their money. Simply stated, they are 100% allocated to positions that make money. There is no other consideration. Outperformance relative to a benchmark, like the Dow or the S&P 500, is utterly meaningless. Arbitrary allocation to certain asset classes do not exist. There is no “bond/equity ratio”, owning your age in bonds, or other such nonsense like that. Funds may be entirely involved in equities one month, in bonds the following month, and in currencies the one after that.

 

3) The world is your oyster. You can invest in stocks, bonds, commodities, currencies, precious metals, ETF’s, and mutual funds. Hedge funds usually focus on areas that have the greatest visibility of future appreciation because of some competitive edge they posses. So you find doctors running biotech funds, Texas oilmen managing energy funds, and computer nerds advising technology funds. In the long/short global macro space, your competitive edge is me, The Mad Hedge Fund Trader.

 

Hmmmm. Where Shall I Go Next?

4) Don’t Quit Your Day Job. If you have a day job and can’t check your email until you get home at night, you need a portfolio that holds positions for weeks or months, and requires minimal hand holding. If you live and breathe markets 24 hours a day and keep your trading screen in your bedroom so the trade alerts can wake you up in the middle of the night, you can afford a greater level of intensity. And whatever you do, don’t quit your day job until you get a few years of experience under your belt.

5) That’s Back Book, Not Black Book! You will often hear me talking about a back book. That is where you bury your sleeper positions that you know will go up someday, you just have no idea when. This is also where you often get your biggest returns. I put the rare earth producers Lynas Corp. (LYSCF) and Avalon Rare Metals (AVARF) on my back book a few years ago, figuring that with the world going nuts over hard assets, this obscure corner of the strategic metals market would get discovered someday. That “someday” turned out to be three weeks later, when it was off to the races for a 400% gain. Depending on your time frame and goals, you can put 20% to 40% of your portfolio in your back book. 

6) The Attack of the Clones. I have carried out a risk analysis on hundreds of hedge fund portfolios over the decades, and a common error is what I call “cloning”. The manager believes he has diversified, when in fact, he has the identical position on multiple times. Then, all of a sudden, a “black swan” event occurs, and “poof!” it is all gone. I’ll give you a classic example. Let’s say you like the Australian, Canadian, and Singapore dollars and strap on three 20% positions. In reality, you are 60% short the dollar. Then all of a sudden, another European debt crisis hits, the dollar takes off like a scalded chimp, and you take a trip to the cleaners. Many traders are facing exactly this quandary this week. To be seasonal, the family jewels are caught in a nutcracker. To me, diversification always meant losing money in more exotic places with funny sounding names.

7) Don’t Confuse Leverage With Brilliance. I often here of young traders making triple digit returns. But when you quiz them on exactly what they have on board, it turns out they are 1,000% long some obscure, illiquid security, like say, subprime loans. Then a hiccup occurs, and they go missing in action. It’s like the Gestapo came and took them away in the middle of the night. Do your homework, read this letter and other sources, practice assiduous risk control, and making 10%, 20%, or 30% on a non leveraged basis is not that hard. Most US mutual fund managers would kill for these returns. I even know some managers who made over 100% this year, non leveraged. This means never investing more than 100% of your capital. Leverage is like crack cocaine. Short term, it gives you a wonderful buzz, long term it is fatal.

No, You’re Not a Great Trader 

8) Living on the Wild Side. That said, many hedge funds do use some leverage successfully. A classic balance for long/short equity funds is 125% long/25 short. Foreign exchange traders often take 300% to 500% positions, because the volatility of their instruments is so low. Market neutral funds, where longs equal shorts, frequently go up to 200%. These strategies can work, but require a level of sophistication beyond most individual investors. Just because you can catch a pass from your little kid in the back yard doesn’t mean you’re ready to play for the NFL. If you do feel like making bigger bets, limit exposure over 100% to intraday positions only.

Don’t Try this at Home

9) The Deep End of the Pool. The bigger funds use leverage to the max. They have fulltime risk managers who spend their days haggling with margin clerks over how much collateral to post that day. Prime brokers, custodians, and the exchanges are all prone to boosting collateral requirements without notice, triggering distress sales and a mad scramble for cash. I had a chance to examine the Long Term Capital Management portfolio when they were going under. They had $4 billion securing $100 billion in positions. All it took was a temporary ripple in the credit markets, and they were history. When my former settlement clerk and later rogue trader, Nick Leeson, took Barings Bank under in 1995, the leverage was even more extreme. This is not for you.

Not for the Retail Trader

10) Scaling is Important. Warning to doctors and engineers! You are lousy at execution. That is because your professions require exactness, precision, and certainty. You only feel secure buying absolute bottoms and selling perfect tops. But you miss these, watch positions go up, panic and end up buying tops and selling bottoms. I have watched you guys do this reliably for 40 years, losing money hand over fist in the process.

News flash! Markets are about inexactness, imprecision, and uncertainty. They are the sum total of the emotions of its billion participants. So picking tops and bottoms is a mug’s game. Scale in by moving into and out of positions in thirds. When you decide to pull the trigger, start with a third, buy a second third on a dip, and the final third on a breakout rally. If you are fortunate to nail a technically significant level, you might upgrade this to halves.

Scaling is Important 

Bottom Line: It is still all up to you. But at least you now have a few guidelines to work with going forward. Start small, and as you rake in a few winners and your confidence builds, increase your exposure. At the Navy flight school at Miramar, home of the famous “Top Gun” combat flying school, they taught me an expression that I’ll never forget. “It is far better to be on the ground wishing you were flying, than to be in the air, wishing you were on the ground.

I think the same thing applies to trading too. Good Luck!

*Post courtesy of John Thomas at the Mad Hedge Fund Trader.

 

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