Contents Foreword Preface Acknowledgments Part One: Macro Men Chapter 1: Colm O’Shea Addendum: Ray Dalio’s Big Picture View Chapter 2: Ray Dalio Chapter 3: Larry Benedict Chapter 4: Scott Ramsey Chapter 5: Jaffray Woodriff Part Two: Multistrategy Players Chapter 6: Edward Thorp Chapter 7: Jamie Mai Chapter 8: Michael Platt Part Three: Equity Traders Chapter 9: Steve Clark Chapter 10: Martin Taylor Chapter 11: Tom Claugus Chapter 12: Joe Vidich Chapter 13: Kevin Daly Chapter 14: Jimmy Balodimas Chapter 15: Joel Greenblatt Conclusion Epilogue Appendix A Appendix B About the Author Index Other Books by Jack D. Schwager A Complete Guide to the Futures Markets: Fundamental Analysis, Technical Analysis, Trading, Spreads, and Options Getting Started in Technical Analysis Market Wizards: Interviews with Top Traders The New Market Wizards: Conversations with America’s Top Traders Stock Market Wizards: Interviews with America’s Top Stock Traders Schwager on Futures: Fundamental Analysis Schwager on Futures: Managed Trading Myths & Truths Schwager on Futures: Technical Analysis Study Guide to Accompany Fundamental Analysis (with Steven C. Turner) Study Guide to Accompany Technical Analysis (with Thomas A. Bierovic and Steven C. Turner) Copyright © 2012 by Jack D. Schwager. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Schwager, Jack D., 1948– Hedge fund market wizards : how winning traders win / Jack D. Schwager. p. cm. Includes index. ISBN 978-1-118-27304-3 (hardback) 1. Floor traders (Finance). 2. Hedge funds. I. Title. HG4621.H27 2012 332.64’524—dc23 2012004861 With love to my wife, Jo Ann, the best thing that ever happened to me (I know because she tells me so, and she has never been wrong) Lara Logan: Do you feel the adrenaline at all? Alex Honnold: There is no adrenaline rush. . . . If I get a rush, it means that something has gone horribly wrong. . . . The whole thing should be pretty slow and controlled. . . . —Excerpt of 60 Minutes interview (October 10, 2011) with Alex Honnold, acknowledged to be the best free-soloing climber in the world, whose extraordinary feats include the first free-solo climb up the northwest face of Half Dome, a 2,000-foot wall in Yosemite National Park To do my vacuum cleaner, I built 5,127 prototypes. That means I had 5,126 failures. But as I went through those failures, I made discoveries. —James Dyson Foreword Once upon a time, a drought comes over the land and the wheat crop fails. Naturally, the price of wheat goes up. Some people cut back and bake less bread while others speculate and buy as much wheat as they can get and hoard it in hopes of higher prices to come. The king hears about all the speculation and high prices and promptly sends his soldiers from town to town to proclaim that speculation is now a crime against the state—and that severe punishment is to befall speculators. The new law, like oh so many laws against the free market, only compounds the problem. Soon, some towns have no wheat at all—while rumor has it that others still have ample, even excess, supplies. The king keeps raising the penalty for speculation, while the price of wheat, if you can find any, keeps going higher and higher. One day, the court jester approaches the king and, in an entertaining sort of way, tells the king of a plan to end the famine—and to emerge as a wise and gracious ruler. The next day, the soldiers again ride from town to town, this time to proclaim the end of all laws against speculation—and to suggest that each town prominently post the local price for wheat at its central marketplace. The towns take the suggestion and post the prices. At first, the prices are surprisingly high in some towns and surprisingly low in others. During the next few days, the roads between the towns become virtual rivers of wheat as speculators rush to discount the spreads. By the end of the week, the price of wheat is mostly the same everywhere and everyone has enough to eat. The court jester, having a keen sense for his own survival, makes sure all the credit goes directly to the king. I like this story. The loose end, of course, is how the court jester happens to know so much about how markets work—and how he happens to know how to express what he knows in an effective way. While we may never know the answer for sure, my personal hunch is that the court jester makes frequent visits to the royal library and reads Reminiscences of a Stock Operator by Edwin Lefèvre, The Crowd by Gustav LeBon, Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, and the entire Market Wizards series by Jack Schwager. Trading, it turns out, is the solution to most economic problems; free markets, sanctity of trading, and healthy economy are all ways to say the same thing. In this sense, our traders are champions and the men and women in Jack Schwager’s books are our heroes. Schwager’s books define trading by vividly portraying traders. He finds the best examples, he makes them human and accessible, and he allows them to express, in their own ways, what they do and how they do it. He gives us a gut feel for the struggles, challenges, joys, and sorrows all of them face over their entire careers. We wind up knowing each of his subjects intimately—and also as a uniquely complete expression of repeating themes, such as: be humble; go with the flow; manage risk; do it your own way. Schwager’s books are essential reading for anyone who trades, wants to trade, or wants to pick a trader. I go back a ways with Jack. I recall meeting him while we were both starting out as traders, long on enthusiasm and short on experience. Over the years, I watched him grow, mature, and develop his talent, evolving to become our Chronicler-General. Schwager’s contribution to the industry is enormous. His original Market Wizards inspired a whole new generation of traders, many of whom subsequently appeared in The New Market Wizards, and then, in turn, in Stock Market Wizards. Jack’s Wizards series becomes the torch that traders pass from one generation to the next. Now Hedge Fund Market Wizards extends, enhances, and perfects the tradition. Traders regularly use passages and chapters from Schwager’s books as a reference for their own methods and to guide their own trading. His work is an inseparable part of the consciousness and language of trading itself. Some 30 years ago, Jack reads Reminiscences of a Stock Operator and notices its meaningfulness and relevance, even 60 years after its publication. He adopts that standard for his own writing. I notice that books that actually meet that standard tend to wind up in the libraries of traders and court jesters alike, on the same shelf with Reminiscences, The Crowd, and Extraordinary Popular Delusions and the Madness of Crowds. That’s exactly where you find Jack’s books in my library. Ed Seykota Bastrop, Texas February 25, 2012 Preface This volume is part of my continuing effort to meet with exceptional traders to better understand the elements underlying their success and what differentiates them from the multitude of pedestrian market participants. The traders interviewed range from the founder of the largest hedge fund in the world, managing $120 billion in assets with 1,400 employees, to a manager running a solo operation with only $50 million in assets. Some of the managers trade from a long-term perspective, holding positions for many months and even years, while others focus on trading horizons as short as a single day. Some managers utilize only fundamental data, others only technical input, and still others combine both. Some of the managers have very high average returns with substantial volatility, while other managers have far more moderate returns, but with much lower volatility. The one characteristic that all the managers share is that they have demonstrated an ability to generate superior return/risk performance. Because so much of what passes for high returns merely reflects a willingness to take more risk rather than being an indication of skill, I believe that return/risk is a far more meaningful measure than return alone. In fact, the fixation of investors on return without the appropriate consideration of risk is one of the great investment mistakes—but that is a story for another book. One return/risk measure that I have found particularly useful is the Gain to Pain ratio—a statistic that is explained in Appendix A. There were three key criteria for selecting interviews to be included in this book: 1. The managers had superior return/risk track records for significant length periods—usually (but not always) 10 or more years and often much longer. 2. The managers were open enough to provide valuable advice about trading. 3. The interviews provided sufficient color to allow for a readable chapter. A half dozen of the interviews I did for this volume were not used because they fell short in one or more of these categories. Over longer-term intervals (e.g., 10 years, 15 years), hedge funds consistently outperform equity indexes and mutual funds.1 The typical pattern is that hedge funds, as a group, will have modestly higher returns, but far lower volatility and equity drawdowns. It is ironic that in terms of any type of risk measure, hedge funds, which are widely viewed as highly speculative, are actually much more conservative than traditional investments, such as mutual funds. It is primarily as a consequence of lower risk that hedge funds tend to exhibit much better return/risk performance than mutual funds or equity indexes. Moreover, with rare exception, the best managers are invariably found within the hedge fund world. This fact is not surprising because one would expect the incentive fee structure of hedge funds to draw the best talent. When I conducted the interviews for my first two Market Wizard books (1988–1991), hedge funds were still a minor player in the world investment scene.2 Based on estimates by Van Hedge Fund Advisors, total industry assets under management during that period were in the approximate $50 billion to $100 billion range. Since that time, however, hedge fund growth has exploded, expanding more than twentyfold, with the industry currently managing in excess of $2 trillion. The impact of hedge fund trading activity far exceeds its nominal size because hedge fund managers trade far more actively than traditional fund managers. The enhanced role of hedge funds has itself influenced market behavior. With hedge funds accounting for a much larger percentage of trading activity, trading has become more difficult. In some strategies, the effect can clearly be seen. For example, systematic trend-followers did enormously well in the 1970s and 1980s when they accounted for a minority of futures trading activity, but their return/risk performance declined dramatically in subsequent decades, as they became a larger and larger part of the pool. Too many big fish make it more difficult for other big fish to thrive. Even if one does not accept the argument that the greater role of hedge funds has made the game more difficult, at the very least, it has made the game different. Markets change and good traders adapt. As hedge fund manager Colm O’Shea states in his interview, “Traders who are successful over the long run adapt. If they do use rules, and you meet them 10 years later, they will have broken those rules. Why? Because the world changed.” Part of that change has been brought about by the increasing prominence of hedge funds themselves. Not surprisingly, virtually all of the traders interviewed in this volume are hedge fund managers (or ex–hedge fund managers). The one exception, Jimmy Balodimas, a highly successful proprietary trader with First New York Securities, had to adapt to the presence of hedge funds. In his interview, he describes how hedge fund activity changed the nature of equity price movements and how he had to adjust his own approach accordingly. Markets have changed in the generation since I wrote the first Market Wizards book, but in another sense, they have not. A bit of perspective is useful. When I asked Ed Seykota in Market Wizards whether the increasing role of professionals had changed the markets (a shift that the intervening years have demonstrated was then only in its infancy), he replied, “No. The markets are the same now as they were 5 to 10 years ago because they keep changing—just like they did then.” In many of the interviews, traders made reference to one or more of my earlier books. I did not include all such references, but I included more than I was comfortable doing. I am quite cognizant how self-serving this may appear to be. My guideline whether to include such references was to ask myself the following question: Would I include this comment if the reference were to another book, rather than my own? If the answer was yes, I included it. Readers who are looking for some secret formula that will provide them with an easy way to beat the markets are looking in the wrong place. Readers who are seeking to improve their own trading abilities, however, should find much that is useful in the following interviews. I believe the trading lessons and insights shared by the traders are timeless. I believe that although markets are always changing, because of constancies in human nature, in some sense, they are also always the same. I remember, when first reading Reminiscences of a Stock Operator by Edwin Lefèvre nearly 30 years ago, being struck by how relevant the book remained more than 60 years after it was written. I do not mean or intend to draw any comparisons between this volume and Reminiscences, but merely to define the goal I had in mind in writing this book—that it still be meaningful and useful to readers trading the market 60 years from now. 1All the performance statements made in reference to hedge funds as an investment category implicitly assume hedge fund of funds data. Indexes based on fund of funds returns largely avoid the significant statistical biases inherent in hedge fund indexes that are based on individual manager returns. 2Market Wizards, New York Institute of Finance, 1989. New Market Wizards, New York, HarperBusiness, 1991.