Its all about the edges

Portfolio Management
Nikki Yu (Faceless Trader)

Its an INEFFICIENT world Filled with

opportunities

Anybody who declares that they think markets are

efficient will be kicked out on the spot. If you
think markets are efficient, theres nothing for
you to do here. But you shouldnt worry about
being kicked out because if markets were truly
efficient, then you wont have any trouble
immediately finding an equally attractive job
somewhere else.

A trader/investor/fund managers job is to turn risk into

profit.

Constraints:

Are you bothered with daily mark to market pressures?

If a position goes against you, are you forced to cut

positions due to investor pressure? Stop-loss rules or other
exogenous constraints?

Can you continue to hold a security underperforming and

just collect dividends until the stock recovers?

Whats your investment horizon?

Psychology and Economics

Psychology is the most fundamental aspect to

understanding financial markets. To some people, this
alone provides an edge of 30%/year gross of fees.

Big directional moves afford patience. Can you be a

horizon trader? Can you truly be an intermediate term
market practitioner?

Staying power can be confused with a lack of discipline,

but it depends if you survive and are profitable. One
mans staying power is another mans foolish lack of
discipline.

Your Edge Can Come From Not Being

Short Term

Everyone today engages in time-horizon arbitrage. All investors these days

are trading very short-term. Everyone seems to be held to parameters that
dont allow for any volatility in earnings and portfolios. Thats a good thing
that you want to exploit. You dont have to follow everyone. Usually market
consensus tends to be wrong. This difference in time frame gives you an
edge.

When things get crowded, adapt your strategy in light of everybody else.

Analogy: In a jam packed room, when fire pursues most people will go exit
through the large door, but there are also small doors in the back that nobody
notices. If everybody is headed a certain way, you might get trampled. The
proper strategy is to head towards the small door at the back even if its not
the most efficient strategy from a physics standpoint. There is higher risk on
a trade when it is a crowded one.

Staying Power

If you move your time horizon to 16 or 24 months, most often you can
extrapolate great swings and be at the winning side.

We do not need to care about market pulse. We need to use that

market pulse or market sentiment to tell us whether our positions
are going from small moves to big moves.

Perception is very interesting. What is your reference point? The

market has been through many cycles. Small moves can be big moves
and other people dont notice them only because they have a
different perspective.

Even a Plain Vanilla Works, Low Cost

Index Funds Work too

The Plain Vanilla Strategy = Not Timing the Market aka Cost Averaging a
Consolidating or Rising Market.

Note--- not a downtrend market. Its not applicable to Long Downtrends.

Eliminating Volatility

Creating Trading Systems How do you feel more comfortable that youre
making the right decisions ?

How does one determine low risk setups?

What are the proper indicators?

Use psychology in timing. Use human behavior.

(Insert the Wall Street Emotion Cycle Chart here)

How To Trade Large Positions

Confidently

Naturally, trading is all about confidence. The more confident you are, the
bigger your position can be and the greater your staying power. But why are
you confident? Couldnt this confidence be foolish arrogance or foolish
invincibility?

The answer is #TAUT The Averaging Up Technique

When things go badly for reasons you dont understand or for reasons that you
understand but arent the reasons you initially got into the trade, you really
should cut the trade as soon as possible. You sometimes have to crush the
market when youre trying to get out to lose a bit more money on the way
out but at least, youre out.

Discipline, the reason why there are

winners and losers in the market

Stop loss is a discipline. It is a very difficult thing to implement for others but
if you have a proper stop-loss, you will never blow up. Youll be out long
before it gets anywhere near the end.

Pressure to Succeed is a Constraint.

Use this as an edge.

Most funds are trading to a benchmark. When a particular stock rises

favorably, it may work against a fund thats underweight this position. This is
when momentum usually starts. The market may seem pricey at these levels
but youre not effectively trading the stock. Youre trading the sentiment
towards the stock. So long as others have a performance pressure that
allows them to buy the stock even at higher and higher levels, you must
completely forget about what you feel strongly for and allow the magic of
momentum to keep you invested. Sometimes, you might even wish to double
your initial position as it moves favorably in this manner.

The Art of Questioning

Have you cross examined most of the common trading strategies? Have you
studied in depth the meaning of Buy Low, Sell High? New High Means
Higher?

Have you asked yourself the fundamental questions? Whos the buyer and
Whos the seller?

Have you asked yourself What composes the market?

Does everyone allocate capital in the same risk tolerance? Same time frame?
Same budgets?

These reflections provide edges you can exploit upon.

Everyones not the same and yet everyone assumes a cookie cutter style or
pattern in trading. Exploit these inefficiencies.

The Greatest Trends

If you want to win, you have to ride the greatest trends of all time.

If you want to win, you dont have to be the first to start a trend, you
only have to be large in a trend and go with it.

Its hard to stay in a trend without encountering volatility, ranges and

black swan events. You thus have to learn the art of managing your
trades by holding a core and trading a position.

Market Extremes are Profitable

Opportunities

Extremes give you high bearish sentiment indicators allowing you low-risk
setups.

#BTFP or #BTFV (Buy the Fucking Panic or Buy the Fucking Puke or Buy the
Fucking Vomits!)

Given all of the imbalances out there, history tells you if an apple doesnt
come lying down the floor for you to pick it up, just wait for time to let a
trade come to your fingertips.

Opportunities come. You get more lucky finding more opportunities the more
you work harder and hone your trading skills.

Acknowledge Luck. It Plays a Role.

Egotistical people dont believe this. Thats their problem. Theres a saying by
George Miller: Do not confuse brains in a bull market. Appreciate the crucial
determinants of success. Appreciate that luck plays a major role in trading at
times.

Conventional finance theory doesnt work. People are not rational. We dont live
in an efficient market. We dont react to a piece of news in the same way.
Whats important is positioning and sentiment.

Positioning = Surprise Factor. If a company exhibits a positive or negative earnings

surprise, how are most funds positioned? That gives you the setup on how to
trade.

Identify the forces that affect the trade. If a lot of funds are positioned
negatively, you would lose money holding that position before these funds
underperform. Obviously, you might have a different time horizon or different
objective but take the notion of beauty contest in terms of price action.

The Beauty Contest Principle of Keynes

Keynes compared the art of selecting stocks to correctly predicting the

winner of a beauty contest. Keynes wrote its not the case of choosing which
faces, to the best of ones judgment, is really the prettiest, nor even those
which average opinion actually thinks is the prettiest. We have reached a
third degree where we devote our intelligences to anticipate what average
opinion expects the average opinion to be. In other words, selecting a
winning investment becomes a psychological game of predicting what
investments others will select. Ultimately, this is what we call the animal
spirit of investors.

Long markets can remain irrational.

How long can you have bubbles?

How long is the degree of investor bias influencing prices? Decades?

Treat all market practices with skepticism.

Markets are very humbling.

Impressive Technicals

Youd read a lot of articles showing simple technical trading rules, and on
average, they do make money. For some strategies to last 100 years, its truly
a test of time.

To a certain extent, any market practitioner should know all the pure
technical trading systems to know how to navigate the markets.

It is arrogant to be bullish on a position that goes against you.

Information Trading

Sometimes the markets are excited and move around with individual pieces of
information (earnings, disclosures of acquisitions and so forth);
Big outliers cause market reaction. The larger the outlier, the larger the market
discrepancy, the larger the possible trading bounces or momentum strategies one
can employ.

Tendency for some is to react on news on a daily basis. Theres no edge in that.
React on news on a monthly basis. Now were talking.

Good Risk Control is an Edge

Running a fund is a privilege because it gives you independence to build

things, rightly or wrongly. Its a huge privilege to be given the opportunity to
decide for people that could affect a lot of lives. When you have clients who
have put a lot of faith in you, you feel very responsible for their money and
your own money in the fund. You would worry constantly on exogenous
events that can go wrong, that do occur and that could derail any carefully
crafted strategy.

Hence, there is always room for diversification or at least trading control

even if we manage the upside volatility as well.

When is it time to make a big bet?

To begin with, there must be a BIG valuation misalignment.

You must wait for some catalyst to provide confirmation that the
misalignment might be about to correct. The catalyst could be technical. It
could be news, it could be flows. It can be anything that takes a trade thats
been part of your radar screens that has finally come into play.

Research a reasonable size read a lot of research. There are plenty of

good ideas out there and you try to figure out what the consensus is thinking.
Talk to managers. Talk to wall street analysts covering the industry. Talk to
policy makers. Talk to a host of people.

Concentrate the firepower (the ammo) to the one where the risk/reward
ratio is the most compelling.

Do not ever break Risk Management

Rules

Do not be seduced by a trade reasonably going well, that you become

complacent.

Do not be seduced by stories that you might have elevated valuations and you
start believing valuation models of ordinary people.

Unwinding crowded positions is an art.

Some of the best momentum monsters (#MoMos) can drop like a stone and
end awry.

When your stops are reached, you dont ask any questions. You just get out.

Getting back into a trade to make back the losses is a bad argument.

Shortermitis is a disease afflicting

many. Use and exploit this edge.

A lot of inefficiencies are a product of things that havent changed. This is

the lack of long-term investing in markets. All of us would rather have
shorter horizons and dont have the ability to hold things to maturity.

Efficient market guys say if theres a $100 bill lying in the pavement, it
always gets picked up. My view is that it sometimes gets picked up and more
$100 bills appear.

Use irrational inefficiencies in the market to make money.

The Real Markets Isnt a Zero Sum Game

In the equity markets, there is genuine wealth creation.

If there is an anomaly, such as higher sales and higher earnings for certain
companies, those investors with a long term horizon reap the rewards for
taking their time to slowly take profits instead of the nimble funds trying to
take advantage of every minute news flow and seeking trading advantages
from the majority of the short-term crowd.

The public is truly going to make money over time and make spectacular
returns, true paths to wealth if youre right in betting on the megatrends.
The term mega-trends by default last at least five years or decades of long
boom. Whether this is a country, or a companys product, your goal is to
invest in those trends early and ride it.

Peter Thiel
Former CEO and Cofounder of PayPal; Clarium
Capital
Peter is very different from all global macro managers. He launched his own
fund in October 2002 with investors tripling their money from 2003-2005.
Clarium was the standout performer in global macro. He credits his global
macro vision with his success as a former technology entrepreneur. Many of his
major trading themes have centered on the lingering impacts of the bursting of
the bubble.
Thiel is a deep thinker with varied interests. He has degrees in philosophy and
law from Stanford, has practiced law, traded derivatives at Credit Suisse
Financial Products (CSFP) and ran his own venture capital fund prior to starting
PayPal. Hes a master in chess and is a former California math champion. In
addition to running Clarium, Thiel is active in Libertarian parties, home of
prominent intellectuals such as Milton Friedman.
Hes only in his 30s.

Success breeds naysayers. Was Thiel lucky or good?

Thiel has profited from bubbles from the way up and on the way down.

Thiels army? young, highly intelligent, loyal, hardworking colleagues. Many

scored 1600 in their SATs, valedictorians of their highschool classes, brainiacs
funneled through Stanford and then into Silicon Valley and then into Clarium.
Why not be loyal when success of Thiel also made them all fortunes?

Thiel is paid a fixed management fee for all investors in his fund and gets paid
for success, 25% of all profits versus the industry norm of 20%.

Macro-Investing or Macro- Trading

People who Profit by Seeing The Big Picture

A macro manager can extract value wherever it exists. He isnt pigeonholed

by conventional arbitrage and the like, where managers are imposed with
performance pressures and style blinders.

Macro demands that a manager think broadly about the world, and varied
background is helpful and is an edge here. Philosophy, Law, Derivatives, Math
and Technology. Thats a breadth of experience.

Peter Thiel knew he was good at macro investing when he raised $100M at the
peak of March 2000 for Paypal. The deal closed on March 31, the last day
before the market began its slide in earnest. Had we done what everybody
else was doing, which was to ignore the forest and just work on our particular
tree, we wouldnt have seen this enormous forest fire coming and we would
have been burned along with everybody else. That drove the importance of a
macro view.

Recognizing Opportunities. Capitalizing

on Them.

Chance favors the prepared mind. Being in Silicon Valley as the tech boom
began was a very fortunate turn of events. But capitalizing on those
opportunities required recognizing them in the first place and then building a
team to see our insights to execution.

There are many imbalances in the world. It is up to us to work hard and

capitalize on them.

Because of that big picture view, macro is intrinsically very interesting.

There isnt much that is more engaging than thinking about how the world
works. Part of the joy of global macro is that its driven by a search for the
right questions as well as the right answers. Being able to pose your own
questions, questions that are answerable and where the answer tells you
something new and important about the world is very exciting.

Themes Take Time to Play Out

Multi year propositions

Themes can take months or even years to mature.

It requires a coherent vision and patience.

Great ideas start from open-ended searches. Options are limitless. You work
with the business, government, consumers, you pick your product, you locate
wherever you want.

Markets and Chess

At the start of the game, you can play any set of moves. As the game progresses,
you become locked into a strategy.
Hedge funds are challenging. Everything is completely transparent. Your
positions are visible to investors which means youre evaluated in real time.
Because of real-time monitoring, your funds life span can be much more
emotionally volatile than at a startup. Fairly large swings are normal, but they
can cause both depression and euphoria. Managing those emotions is an
important function of running a fund.
Our best relationships are with investors who appreciate macros longer horizons.

On Private Discussions and Public Forums

Investors are a fine source of information. They are also incentivized to give
you good information, even if you end up arriving at different conclusions.

Investors should try to understand the managers though process, if it seems

sound then the relationship will probably work. Does the analysis make
sense? Is it cohesive? Is it novel? Are conclusions well supported? Listen to
managers arguments and consider.

Investors incur a significant opportunity cost in the form of profits foregone

because investing will never be perfect. Some ideas takes a few months to
take off. Some ideas take a significantly long time.

Choosing Styles

Some styles are impossible to be deployed with $100M caps. On the other
hand, macro can deploy a huge amount of capital.

Markets have become highly correlated. Broad diversification is neither

practicable nor desirable. Many of the distortions are interlinked so themes
are highly scalable.

A substantial portion of outperformance is driven by a limited number of

trades, thats often the case in life and investing generally. --- a few stellar
winners.

(show the fund returns from Zero to One book)

Creating Edges

Spend an enormous amount of time reading

Watch the markets and test the theories

Read extensively on many topics

Spend time talking with people internally and externally (talk to experts)

Dig further, get broad perspectives

Timing and Exposure Management

Look at whats happening

Look at peoples positioning

Limit losses to disaster scenario of 15-20%

Adjust overall size and place stop losses on each individual trade

Strict Stop Loss Points. Strict Discipline.

Do not get obsessed about a single trade.

Be willing to ride out short term drawdowns if the position is in the black. Be
comfortable when a winning position moves a little bit against us. Have a
larger trail stop for winners. Let them play themselves out. #BTFD on your
winners. Add on your winners on dips.

World Views
Balancing long term and short term views on the pivot of timing indicators is very
tricky.

There are two ways of thinking about the world. Either

were living in a normal world or something extraordinary
is happening. If you think were all living in a normal
world, theres no point in macro investing. But if you
think were living in a world distorted by bigger financial
bubbles that weve never seen, there are things that are
likely to break in asymmetric ways. This presents
enormous opportunities. We are clearly in the
opportunity camp.

Creating Edges

Math, Economics and History.

You need to be able to do quantitative modeling. You must understand

economic theories that drives the numbers in the model and you must have
history to provide a sense of context.

Great analysts like their job. They like math, they like economics and they
like history. They are naturally interested in these subjects.