From the November 01, 2008 issue of Futures Magazine • Subscribe!

Herbert: Taking the heat

Phillip Herbert’s theory on the market is simple - if you want to make money, you have to withstand the heat. He and his partner Alan Zenk liked this theory so much that they named two of their managed programs, Shadrach and Abednego, after a similarly themed Old Testament parable. “Shadrach and Abednego were thrown into the fire, and they survived. In markets, you have to be able to have your feet to the fire and come out alive,” he says.

Herbert began investing in the stock market at 18 with money from his summer job as a garbage collector. “The first stock I ever bought was a small restaurant company that tripled in value, and right then and there I was hooked. I was making some very good money for a 19-year old kid. My performance wasn’t because I really knew what I was doing, but it was because we were in a bull market [from 1982-86].”

The stock market crash of 1987 taught him the importance of risk management. He joined Paine Webber as a stock broker after college, around the time of the crash. “I started my career in a time when people were getting absolutely decimated. I’ll never forget the looks on the other brokers’ faces. There are unprecedented events that could happen literally overnight that have a drastic change on your portfolio. You have to control your downside at all times so something crazy doesn’t happen and take you out of the game,” he says.

After five years at Paine Webber, he worked as a retail broker for Prudential Bache Securities. In 1993, he opened the Minneapolis branch of All-Tech Investments, a brokerage firm specializing in day-trading. “I started my own broker-dealer with the intent of trading cheap. At some point in time I gave up the actual management of the company and traded for myself full time,” he says.

By 2001-02, he began trading hog futures with some friends out of Chicago, using calendar spreads. “I saw a change in the world away from financial assets into commodity assets because of the rate at which our government was printing money and the growth in China and India. I wanted to get into that marketplace because of the huge opportunity,” he says.

Herbert and Zenk got into the hog management business when they started a commodity pool called Golden Harvest Partners. “The commodity pool grew very fast because the returns we had were excellent,” Herbert says. In 2004, they launched the Shadrach and Abednego programs at NDX Capital Management. The two livestock programs consist mainly of hog calendar spreads and use both technical and fundamental analysis. Technical factors such as price, volatility, time and open interest and fundamental factors such as seasonal influences, news events and supply and demand are all considered in trade implementation. Shadrach, which had the number one rating in Barclays for the past three years, is a more aggressive program with three times the leverage of Abednego. “If we’re wrong on [Shadrach], there’s the potential for some significant drawdowns. I will tell [clients] what we could expect on the drawdown. In the right circumstances, we manage it aggressively to try to get some oversize returns,” he says.

Shadrach returned 31.9% in 2006, 8.9% in 2007 and is up 46.33% through August 2008, with a Sharpe ratio of 2.40 since September 2004.

Neither program is incredibly active, instead building their positions over 15 or 30-day periods of time. “A lot of times we’ll just sit on our positions and let them work out,” Herbert says.

In 2007, unexpected conditions in the hog market, such as the doubling price of corn, led Herbert to keep the programs inactive for most of the year.

“We had a lot of complaints in 2007 because we weren’t ‘doing enough’ in the marketplace, but there wasn’t enough to do. I would rather sit there and not do anything than give customers action and lose their money,” he says. “When there’s a significant change in markets, there’s tremendous opportunity, but there’s also tremendous risk. Is it worth risking our client’s money when we don’t understand what’s going to happen? We were able to avoid some pretty nasty markets and as a result of that some institutional money started flowing our way.”

NDX’s third program, Methuselah, is an automated program trading the E-mini Nasdaq and S&P and mini Dow. It had a 30% return in 2007 and a 23.49% return through August 2008. “Given the marketplace that we’re in, I’m leaning towards not doing a lot on the overnight basis because you never know what surprises are going to come up,” he says.

Herbert’s main focus is managing risk. “If we can control our downside, the upside will take care of itself,” he says.

Herbert says NDX tries to avoid getting too wrapped up in the excitement of the markets, which he says can lead to bad trading decisions. “Trading should be boring. We’re not gunslingers. We’re not guys that are going to make a billion dollars overnight because of the massive position we’ve put on – that’s not our style,” he says. That even keel allows NDX to exploit those market participants consumed by the volatility. “We really trade people and their emotional responses to events in the marketplace. When emotions [reach] their peak, that’s when I look to take the other side of the trade.”

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