Efficiently Inefficient
Efficiently Inefficient

Efficiently Inefficient

It made cheap stocks cheaper, expensive stocks more expensive, while leaving overall equity prices relatively unchanged. The effect was invisible to an observer of the overall market or someone studying just a few stocks, but became more and more clearly visible through the lens of diversified long–short quant portfolios. (Location 227)

crisis. I understand why most of the successful managers whom I interviewed for this book emphasize the importance of self-discipline. (Location 235)

The efficient market theory says that, going forward, prices should fluctuate randomly, whereas the liquidity spiral theory says that when prices are depressed by forced selling, prices will likely bounce back later. (Location 244)

All market dynamics pointed clearly in the direction of liquidity and defied the random walk theory (which implies that losing every 10 minutes for several days in a row is next to impossible). (Location 246)

The secret nature of the strategies has justified high fees and reduced entry into the industry. This book puts the main hedge fund strategies out in the open. (Location 313)

However, rather than being based on magic, I argue that much of the world of hedge fund returns can be explained by a number of classic trading strategies that work for good reasons. (Location 327)

Although the different trading strategies and the different hedge fund gurus invest in very different markets and asset classes using different methods, there are nevertheless some common overarching principles that I call “investment styles.” (Location 333)

A discrepancy between the market price and the theoretical value has two possible interpretations: (1) It presents a trading opportunity, where you buy if the market price is below the theoretical value and sell otherwise; if such opportunities arise repeatedly, which can happen for reasons we discuss in detail, they give rise to a trading strategy; (2) The discrepancy can reflect that your theoretical value is wrong. How do you know if the truth is one or the other? You implement the trading strategy— (Location 341)

live trading or in a simulated backtest—and, if you make money, it’s (1) and, if you lose, it’s (2). (Location 345)

Prices are pushed away from their fundamental values because of a variety of demand pressures and institutional frictions, and, although prices are kept in check by intense competition among money managers, this process leads the market to become inefficient to an efficient extent: just inefficient enough that active investors and their money managers can be compensated for their costs and risks through superior performance and just efficient enough that the rewards to money management after all costs do not encourage entry of new managers or additional investor capital. (Location 367)

Liquidity is the ability to transact, so when money managers “provide liquidity,” it means that they help other investors transact by taking the other side of their trades. (Location 377)

As the stock price is bid up, the pharmaceutical firm's cost of capital is lowered, allowing the firm to increase the scale of its operations. Hence, when money managers incorporate new information into prices (i.e., improve market efficiency), this process helps the real economy. (Location 389)

Implementing this trading strategy often requires being contrarian, since companies only become cheap when other investors abandon them. (Location 484)

Almost all equity long–short hedge funds and dedicated short-bias hedge funds (and most hedge funds in general) engage in discretionary trading, meaning that the decision to buy or sell is at the trader’s discretion, given an overall assessment based on experience, various kinds of information, intuition, and so forth. (Location 504)

To do this, they use tools and insights from economics, finance, statistics, mathematics, computer science, and engineering, combined with lots of data to identify relations that market participants may not have immediately fully incorporated in the (Location 509)

While discretionary trading has the advantages of a tailored analysis of each trade and the use of soft information such as private conversations, its labor-intensive method implies that only a limited number of securities can be analyzed in depth, and the discretion exposes the trader to psychological biases. (Location 518)

Whether using discretionary trading or quant methods, learning the analytical tools is useful, and this book aims to provide such tools. (Location 531)

In my interview with George Soros, he explains that he too puts significant emphasis on risk management, but he feels that one should go for the jugular in the rare cases when the upside is large and the downside is limited. (Location 546)

Though global macro traders are very different from one another, there are similarities. For instance, macro traders often like to express their views in a way that earns a positive carry, meaning that they earn income even if nothing changes. (Location 553)

Managed futures investors (also called commodity trading advisors, CTAs) trade many of the same securities as global macro traders: bond futures, equity index futures, currency forwards, and commodity futures. (Location 559)

Convertible bond arbitrage consists of buying cheap convertible bonds and hedging the risk by shorting stocks and possibly using additional hedges. (Location 587)

As a case in point, most of the managers whom I interviewed for this book use some version of value investing (buying cheap securities and selling expensive ones) and momentum investing (buying securities whose price has been rising while selling falling ones). (Location 605)

Soros focuses on boom–bust cycles, but, when he rides a bubble, this is essentially momentum trading, and when he decides that a bubble is bursting as the economy moves closer to equilibrium, he is a value investor. (Location 610)

Carry trading is the investment style of buying securities with high “carry,” that is, securities that will have a high return if market conditions stay the same (e.g., if prices do not change). For instance, global macro investors are known to pursue the currency carry trade where they invest in currencies with high interest rates, bond traders often prefer high-yielding bonds, equity investors like stocks with high dividend yields, and commodity traders like commodity futures with positive “roll return.” (Location 643)

Low-risk investing can also be applied as an asset allocation strategy called risk parity investing, and has also worked in fixed-income markets. (Location 650)

The word hedge refers to reducing market risk by investing in both long and short positions, and the word fund refers to a pool of money contributed by the manager and investors. Asness has provided a tongue-in-cheek definition: (Location 692)

Clearly, investors prefer higher SRs, as they prefer higher returns and lower risk (but their preferences might be more complex than what is captured by the Sharpe ratio when hedge funds have skewed returns and crash risk). (Location 917)

The AM ratio can be seen as the investment management equivalent of the return of equity (ROE) measure from corporate finance. (Location 954)

Therefore, the Sortino ratio assumes that investors do not care whether they make 5% in each of two years versus 1% the first year and 9% the next. In contrast, the SR is based on an assumption that investors prefer the former. (Location 970)

The arithmetic average is the optimal estimator from a statistical point of view, and it corresponds more closely to the experience of an investor who adds and redeems capital in order to keep a constant dollar exposure to the hedge fund, under certain conditions. (Location 978)

Hedge funds frequently review what factors are driving their returns, a process called performance attribution. (Location 1082)

It is important to distinguish between performance measures that are gross versus net of transaction costs and gross versus net of fees. (Location 1089)

Hedge funds also consider backtests of their strategies, that is, historical simulations of their performance under assumptions about how they would have behaved in the past. (Location 1094)

believe that there are two main sources of repeatable trading profits: compensation for liquidity risk and information advantages. (Location 1126)

Third, a hedge fund may try to “ride” a bubble rather than trading against it—as George Soros has done for instance during the Internet bubble— (Location 1168)

In summary, when you are looking for new cool trading ideas, think about whether there is information that most investors overlook, new ways to combine various sources of information, a smart way to get the information fast, or what type of information is not fully reflected in the price because of limited arbitrage. (Location 1173)

We want to understand how hedge funds can earn alpha returns as compensation for risks other than simple stock market exposure, importantly liquidity risk. (Location 1179)

Liquidity risk is an important reason why the standard capital asset pricing model (CAPM) does not work well in practice. (Location 1201)

Buying securities falling in value as others are selling large positions in a liquidity spiral can often be dangerous, since it is impossible to know when the bottom has been reached. As traders say, (Location 1229)

Other securities may be abandoned, leading to low prices and high expected returns. In such situations, a contrarian trading strategy becomes profitable, effectively providing liquidity by buying low and selling high.2 (Location 1263)

In summary, you could find trading strategies by getting an edge in trading and financing illiquid securities or by trading against demand pressures. (Location 1282)

Furthermore, we should discount backtests more if they have more inputs and have been tweaked or optimized more. (Location 1341)

While simulating a trading strategy with a careful backtest gets closest to reality, running regressions is another useful tool. (Location 1376)

Reactive risk management is usually a form of drawdown control (discussed in detail below) and stop-loss mechanisms. (Location 1586)

To control risk, a hedge fund often has risk limits, meaning prespecified restrictions on how large a risk the hedge fund will ever take. (Location 1590)

Traders often end up holding onto their positions as prices fall, but eventually they have to cave and sell near the bottom as their funding dries up or panic ensues. (Location 1622)

Funding costs arise when a trader leverages his investments and must borrow money at a higher interest rate than the interest rate he earns on his cash holdings and short sale proceeds. Furthermore, leverage is associated with funding liquidity risk, that is, the risk that the trader cannot continue to finance his positions and is forced to liquidate in a fire sale. (Location 1652)

While a strategy has limited capacity, a hedge fund may have a very large capacity, since it can invest in many different strategies and markets. (Location 1834)

However, in hedge funds, withdrawals are usually subject to initial lock-up provisions and redemption notice periods. If a hedge fund has a lock-up, then when capital is first invested, it can only be redeemed after a certain time period, for instance, one year. (Location 1877)

A classic risk discussed in casinos and statistics books is gambler’s ruin: the risk that you end up bankrupt despite having the odds in your favor. (Location 2008)

A liquidity spiral implies that there exists a crash risk that is difficult to detect during normal trading days. (Location 2039)

I consider three types of equity strategies: discretionary equity investments (chapter 7), dedicated short bias (chapter 8), and quantitative equity (chapter 9). (Location 2096)

Quantitative investors gather data, check the data, feed it into a model, and let the model send trades to the exchanges.1 (Location 2108)

Most active equity investors trade based on discretionary judgment, and many of the most successful ones swear to the principles of Graham and Dodd (Location 2260)

(1973). As is clear from the quote above, this means thoroughly analyzing a firm’s business and its future profit potential, considering whether the management has the ability to deliver on this potential and the integrity to pay the profits out to shareholders, valuing the firm in relation to its price, and acting on your judgment even if it goes against conventional wisdom. (Location 2261)

Good growth is sustainable growth in profits that leads to growth in free cash flows. Bad growth is growth in other numbers that ultimately hurts profits. (Location 2379)

Said differently, Buffett has been buying cheap, high-quality stocks, and such stocks have performed well in general, which helps explain Buffett’s success. (Location 2450)

Berkshire’s volatility of 25% is significantly higher than that of the market, in part because Buffett has leveraged his equity investments about 1.6-to-1. (Location 2457)

Design of a portfolio involves at least four steps: deciding which asset classes to include and which to exclude from the portfolio; deciding upon the normal, or long-term, weights for each of the asset classes allowed in the portfolio; altering the investment mix weights away from normal in an attempt to capture excess returns from short-term fluctuations in asset (Location 3728)

The strategic asset allocation of large institutional investors is naturally focused on market risk premiums, specifying the allocation to equities (equity risk premiums), government bonds (term premiums), corporate bonds and other risky debt (credit risk premiums), illiquid and real assets such as real estate, forestland, and infrastructure (liquidity risk premiums), as well as the cash reserves. (Location 3759)

For instance, a multi-strategy hedge fund must decide on its allocation across the different equity strategies, arbitrage strategies, and macro strategies and how to vary the allocations over time. (Location 3768)

Risk parity investment is based on the idea that the different major asset classes—equities, bonds, credits, and real assets (commodities and inflation-linked securities)—have similar Sharpe ratios. (Location 3816)

Market timing rules can be analyzed using regressions and backtests (as also discussed in chapter 3). To be specific, let us consider how one might time the equity market based on the dividend yield. (Location 3834)

Equity carry trade: The carry of an equity is its dividend yield, so an equity carry trade is to invest in equity futures with high dividend yields while shorting ones with low dividend yield. (Value investors also look at dividend yield, so, for equities, carry is closely related to value.) (Location 4194)

My theory doesn’t tell me, because it’s actually unknowable, because it’s not predetermined. It’s determined by the actions and the attitudes of market participants and regulators. (Location 4586)

GS: Well, I take very large positions only when there is an asymmetry. For instance, betting against the European exchange rate mechanism was a low-risk bet. By taking a very large position, I wasn’t taking a large risk. That was also the case when John Paulson took a very large position against subprime mortgages because there was a disparity between the risk and the reward—he learned that from reading my book. (Location 4600)

Well, generally speaking, you should not risk a significant part of your capital. Therefore, if you have a good run and you’re making a lot of profit, you can risk your profits more than you can risk your capital. (Location 4610)

The acquirer can be another company with potential synergies, that is, a strategic buyer, or the acquirer can be a (private equity) leveraged buyout (LBO) fund. (Location 6244)