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Why black box hedge funds should have lazy risk managers

At the time of writing Astra Zeneca stocks are up around 15% over a few days at the back of a approaching takeover provide. I own a chunk of those and my fingers had been twitching over the 'promote' button with the herbal inclination being to take profits as any behavioural finance textbook will inform you.

Indeed I am now not the handiest one http://www.Telegraph.Co.United kingdom/finance/personalfinance/investing/stocks/10794055/AstraZeneca-shares-are-up-14pc-in-a-week.-Should-I-sell.Html.

The part of my mind walking what Daniel Kahneman in http://en.Wikipedia.Org/wiki/Thinking,_Fast_and_Slow calls System one is on top of things. But the identical rapid instinctive behaviour that made sense whilst our ancestors had been hunting woolly mammoths thousands of years ago is not numerous use in this situation. The different part of my brain, System two, knows that logically I need to examine some information and see whether or not it honestly does make sense to promote or to grasp on. After all analysing facts is quite a lot what I do.

Enter the black container

I could really do with some kind of rule to tell me whether I should go ahead. That means I would be less likely to succumb to temptation. Three classic trading strategies that would apply in this situation are 'momentum', 'value' and 'merger arbitrage'. The first would say 'price has gone up, buy or hold a long position as it should go up more'. The second would tell me that the dividend yield on these shares has gone done to around the FTSE 100 average so I should probably sell. The latter would say 'Hold the shares until the merger is complete'. Incidentally two out of three these strategies would not sell; one reason they tend to make money in the long run is that they deliberately go against peoples natural (system one) inclinations to take profits early. The second tends to make money by being contrary as well; mainly on the downside people find it hard to buy things that have dropped a lot in price and so represent better value.

Imagine then I have a little black box sitting next to me calculating the correct decisions to make based on one or both of these trading models. Or perhaps more realistically in a separate window on my computer; next to my online brokerage account control panel. Which is resolutely saying as two out of three systems agree: do not sell these shares! But there is nothing stopping me from doing so. I can just move my mouse over to the window and click sell. The black box, assuming it has some kind of data feed to read my positions, will then change its recommendation to a slightly churlish buy Astra Zeneca – unlike me it won't have changed its mind and thinks we should be owning this still British pharma company until the bitter end.

If I then rang a friendly economist (they do exist) he or she would tell me what I need is a commitment mechanism. This is some way of preventing me from pulling the trigger and ignoring my black box. Similar in fact to when a gambling addict requests that he be barred from an online poker site. Yes the irony of the analogy isn't lost on me either. So perhaps I could set up my black box so it automatically submits the trades for me. Note that I no longer just have a systematic strategy for investing, but one which is fully automated. Just to be on the safe side I should also hide my brokerage account password deep within my computer so it takes me a few hours to dig it out.

Borrowing the Black Box

There is a much simpler manner of attaining this but, which could also unfastened up some spare time to do greater socially beneficial and amusing sports. I just want to invest my money with a hedge fund which specialises in merger arbitrage and/or momentum buying and selling. We can ignore for the instant the problems faced by using small retail buyers in trying to open accounts with hedge finances. Also this can now not be cheap; I will should pay at least 2% of my funding each year in costs and likely quit a 5th of any earnings.

But I can do even better by finding a systematic hedge fund, i.e. one which has its own black boxes. This should be cheaper; black boxes are less greedy than shouty blokes in red braces (human traders), even after you have paid some geeks to come up with the models and program them in. In practise it tends not to be cheaper with the resulting higher operating margin going to the funds owners or staff, but that is another story. It is also hard to find systematic merger arbitrage funds but fortunately equity valuation funds are two a penny, and systematic momentum funds are also quite common. Indeed I actually used to work for such a fund. By the way anything in this post isn't necessarily a reference to that particular fund or its employees. It could be about any large systematic hedge fund owned by a publicly traded UK listed company.

One guy and his canine (and his laptop)

There is a high-quality clich? Within the systematic funding industry, which I suppose became stolen from a well-known quote approximately the distance programme. The ideal systematic fund must encompass a laptop, a human and a dog. The pc does the trading at the same time as the human feeds the canine. The dog's process is to chew the human if he goes close to the pc. In training you do want to have people concerned inside the walking of these items. What type of things would possibly they be doing?

  • Process control. Its almost impossible to design a system which is completely automated. Much easier and safer to make something that requires an occasional knob to be twisted, or rather a particular script to be manually run.
  • Data cleaning. Cruddy prices are more common than you think.
  • Watch dogging. In case of bugs, incorrect inputs or data, something falling over …. you don't want the computer running amok and trying to trade the entire GDP of Korea in one bond trade. Famously a number of firms trading high frequency strategies have managed to lose their entire capital in a few seconds.
  • Improving the strategy, i.e. research.
  • Extending the strategy to a wider number of tradeable instruments.
  • Reparameterisation; necessary if something changes. If you are running a slow trading strategy this shouldn't be happening very often. High frequency traders need to refit their models frequently. Arguably overlaps with research.
  • Exogenous risk control. A good fund will have endogenous risk control, i.e. the risks the models know about are controlled within the models. If a model doesn't know about the risk then you need to exogenously do something about it.

Quite a few of these sports can at the least be partly automatic, except for studies (automatic research is simply reparameterisation). As with hazard manage you can view these as endogenising the pastime within the black container. I always attempt to pass any exogenous advert-hoc activity in the box; first via systematising it and then by automating it. For instance suppose you acquire anxious approximately executing orders around vital non farm payrolls. First you may simply flip off your buying and selling device when a big non farm quantity was coming (ad-hoc). Then you may create a procedure in which you grew to become off your trading for each non farm quantity (systematised manner). Finally you may create a records feed for non farm dates and feature the machine pull out just before each one (automated method).

However we're still left with the largest potential source of exogenous hazard manage, or as I prefer to put it 'I recognize instinctively better than the trading model I actually have spent hundreds of man hours growing, due to X' (you may possibly see wherein I am going with this). Often in my enjoy I even have found myself or observed others labelling changes as 'studies' that have been in reality done for threat control motives. For instance 'Our research suggests that we must remove some asymmetrical lengthy bias from our corporate bond bond, company bonds sense overestimated so that is genuinely an excellent time to introduce it'. Notice that the researcher talking here hasn't were given a company bond valuation model so there is no manner of backing up their feelings with information... Its System One now not System Two talking right here.

We also see the equal form of behavioural biases that the systematic buying and selling model has been designed to keep away from coming returned in again. So once more I actually have observed myself saying 'We need to lessen this models danger to take earnings because it has been an awesome year' and specially heard others announcing 'This model hasn't made money for 3 months we must flip it off'. In case you failed to realise 3 months is an statistically useless period of time to measure performance over for the varieties of models we are speaking approximately.

Gut feeling and behavioural bias is human nature and there isn't much we can do approximately it. Instead you need rigorous peer /management reviews of any proposed change or the critical self examination based totally on bitter revel in in case you are in your very own. Another suitable trick is to make the process for making adjustments to the buying and selling machine so bureaucratic, hard and torturous to do that no one bothers. Inevitably though the risk supervisor will bitch loudly if their intestine calls, sorry rigorous analytical choices, are too hard to implement.

Wanted: Risk Manager. Must be wantonly idle

Some extra good advice is not to employ each person with trading enjoy as a hazard supervisor. Normally this is a great concept, since ex-traders understand wherein the our bodies are buried and are tremendous supervisors of human traders. But with a systematic system they'll just need to start making calls. A cardinal rule of walking a systematic gadget is any danger control decision need to reduce the size of a function however never alternate the sign. Ex-buyers locate it difficult to follow that rule. They are also a chunk at risk of what Americans like to call Monday morning quarterbacking. Its very easy to see that a specific position shouldn't have been put on, or need to were decreased, if it loses cash because something happens.

A better character to appoint might be a person who is very smart but particularly lazy, and who can only be troubled to do say one hours paintings a month. Since they still want to receives a commission they'll ensure that they simplest take decisions however most effective whilst it truely matters. You can simulate this with the aid of using a variant of Warren Buffets punched card concept. At the begin of the 12 months the risk manager receives a card. Every time they make a selection they punch a hollow in it. When say 10 holes are in the card you remove their right to make any similarly selections. The equal rule may want to apply to any individual who has the energy to alternate a trading gadget parameter.

Two sorts of traders

Unfortunately it isn't just human nature or over enthusiastic risk managers that causes problems with system one thinking. In theory investors in the fund have deliberately handed over their money at least partly to ensure a commitment to the trading model. Certainly for larger institutions that could run their own money in this way this should be one reason, though most investors probably haven't consciously done this. But sure enough when there is poor performance for 3 months, many will put pressure on the manager to do something. Long lock ups, where you cannot redeem your investment for months or years, are unusual in this kind of hedge fund since the underlying assets are very liquid; indeed this is a selling point. However perhaps for systematic managers it makes sense to attract the right kind of investor by imposing a five year lockup on any money put in.

There is one more source of behaviourally stimulated interference; the owners of the fund control commercial enterprise ? Shareholders and their representatives, the senior control of the enterprise. Fund investors might be au fait with the nature of the commercial enterprise ? Studies the model, implement it after which go away it by myself until its behaviour falls outdoor an predicted envelope in a statistically large way. But if senior managers are from a buying and selling historical past they may also be at risk of the behaviour of the risk managers cited above. Again you might be higher off with very lazy senior control. If its any help I am available and perfectly happy to paintings a few hours a month for a CEO type earnings.

Shareholders in public groups like predictable agencies with consistent coins flows. They connect right rate profits ratios to such businesses. But this sort of commercial enterprise is efficaciously a non linear leveraged play on the achievement of the underlying buying and selling approach. This ends in very lumpy profits, difficult for public shareholders to belly; they may generally tend to overvalue the company while it's miles doing properly and undervalue whilst vice versa happens. Ideally then a hedge fund like this shouldn't be publicly owned, however like nearly all hedge price range owned by its employees. They know higher than all and sundry what the enterprise is like, and that is also remarkable for lining up incentives.

But if it should be publicly owned then it's far clean what the shareholders need to do. Yes: they want to shop for a black container, entrust their hedge fund shares to it and cover their passwords...

To finish its probably worth noting that I only trade futures systematically; thus I really do have no formal trading model at all for Astra Zeneca. If anything my individual share portfolio is definitely value based, so I will probably sell having identified a company with a better dividend yield. When I get round to it that is.

Postscript: I sold my AZN shares on 8th May 2014 and traded them for the higher yielding GSK. Wish me luck!

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