The Shape of Things to Come pt II

Yesterday I talked about how I manage the base equity of my fund. Today I’m going to talk about the leveraged portion.

The first thing I do is to work out if I want to hedge anything. And I hedge for one particular reason. The stock positions in my base equity are designed to be there for two or three years. But with the best will in the world, they ain’t going to be going up in a straight line. And when they do go down, the market has an almost spooky knack of getting them to the point at which I doubt myself, and get tempted to bail out.

I keep the hedges separate from anything else I’m doing in this part of the fund. They’re not absolute bets; they’re not there to make money directly. The hedges are a rod for my back – that I put on when the short term risk/reward for my thematic bets has deteriorated – to give me the stamina to ride out the inevitable corrections.

That’s exactly what I’m doing right now. I have a 60% short position purely as a hedge against my market exposure elsewhere. It’s comprised of shorts on the Dow Jones, the FTSE 100 and Erstebank.

The rest of the fund uses the leverage inherent in futures, CFDs or borrowed money to add anything from 0-400% of exposure onto the base equity. And it’s there for one purpose only – to make absolute returns.

And for that reason, I’m perfectly happy to run zero exposure. That’s what I’m running now. I wrote a while ago about how to lose money. One way – always be fully geared. I only put a position on when I like the risk/reward. And I only like the risk/reward when I think that the market is paying me to take the bet.

I have up to 40 units of risk exposure, each one with an average of 10% of the value of the fund (NAV). I adjust the exact position size according to the volatility of the instrument. I can put from one to four units of risk on any one position. And I hold a maximum of 10 separate positions. If I go four units of risk, say, long gold, then I limit myself to just two units long of something highly correlated – like silver or platinum.

And I build into positions. One risk unit on to start with, and then pre-set double-up points up to get the position up to four risk units.

If this all sounds a little familiar then you’ve probably read one of the books that I’ve read – ‘The way of the turtle’ by Curtis Faith. An excellent book on rule based trading.

Now I’m no black box or technical trader. I make my own judgements on when to get in. But once I’m in, I’ve found that rules pay dividends.

So what’s the advantage of doing it this way?

First, it reduces my mistakes. So I tend to win much bigger than I lose. If I’m in with one risk unit on a trade and I’m wrong, I’m stopped out once I lose a quarter percent of NAV. If I’m right, and a trend forms, I am making money four times as fast, and I can run the position five or ten times as far.

That means I can comfortably lose much more often than I win. It means I can look for a big payoff from an unlikely event. That’s something that most people don’t like to do – so I reckon it gives me an advantage.

And I think this structure diminishes my weaknesses – overtrading, or betting too big when the market’s churning and I’m frustrated. And it likely augments my strengths – betting on good risk/reward trades, and keeping discipline in both cutting and holding.

This approach tends to take a chunk of the emotion out of trading. I’m not stressed because I know exactly how much I’ve got to lose on a trade before I cut. It helps me focus on the fact that it’s not important whether any individual position loses money – as long as I took a good risk/reward bet when I got in. Over time, good risk/reward bets make good money. And I’ve found that the less stressed I am, the easier it is to follow the rules, and the better I am at judging good bets in the first place.

I also think that this risk/reward business is a matter of psychology. There is a massive pressure on funds not to miss out on any significant market moves – with Fund of Funds regularly pruning their worst performers over ever shorter periods – even if that worst performance is just flat in a rising market. So many fund managers internalise that pressure to get involved in a moving market. The problem of course is that this leads to crowded momentum trades - and ultimately vicious reversals.

I’ve found that by keeping a clear eye on risk/reward, I’ve tended to be uncorrelated with other funds, particularly during the big countertrend moves. This makes my fund quite unusual. It doesn’t behave like the average fund, which often ends up looking just like a leveraged long equity bet, with a trailing stop.