FM: In evaluating a trader, how important is it for you to talk to a manager and have that manager describe his approach and explain where his or her edge comes from as opposed to simply examining a track record and looking over offering material?
JS: It is absolutely critical. Track records often don’t have the whole story. In many cases you can’t evaluate a manager based on a track record. Certainly for a majority of the hedge fund world, the risks that are inherent in those strategies are not the types of risk that manifests themselves regularly in their track record. There is sporadic risk. Like trying to evaluate flood risk in an area that hasn’t had a flood in the period that you are looking at. You say, ‘Oh, there is no problem here’, well yes, there is, you just don’t have enough years.
FM: But you do know an option writer has risk even without a drawdown, I want to know what you want to hear from a manager.
JS: The track record does give you some indication of risk. When I am talking to them I am looking for an understanding of what they are doing, an understanding of where the potential edge might come from and what risks are being taken to get that return and is it different from what other people are doing and if there is a reasonable reason to believe that they have a shot of doing better than average. And such things as if they are invested in the fund themselves and how confident are they. There is a fine line between confidence and ego; that is what you try and dissuade, confidence is good, ego is not. You just make your best qualitative assessment. Is it perfect? Is it very reliable? No. Does it give you a little edge? Hopefully.
FM: In the prologue to your most recent book, you pointed out the tendency of investors to lose money in managed futures due to poor timing of investment decisions. This observation was from early in your career, have you noticed this changing?
JS: I noticed that early in my career and I haven’t had access to data to do that analysis again but I would give odds that if you took the results of investors in CTAs and calculated what their annualized returns were from inception, I would guaranteed you that if you then compared that to the CTA’s annualized returns that the investors would be much worse in their results. They should be similar, but if they were actually making decisions as to when to allocate and when to redeem that were detrimental then they would be worse. When I did this [analysis] they were dramatically worse. I am positive that if you did this analysis today, investors in CTAs, and mutual funds by the way, would do much worse than the underlying manager. That is just human nature, I don’t see that changing.
FM: Allocations to CTAs has actually risen over the last two years according to the BarclayHedge database.
JS: If that is true, that money is coming into to CTAs after several years of poor performance, and if there was an increase into CTA allocation after a period of poor performance I would argue that that is coming from large allocators who know what they are doing. But the average individual would more likely be redeeming.
FM: Your first "Market Wizards" book came out 25 years ago; what changes have you seen from both the investor and manager perspective? What have been the changes in the traditional and alternative market space?
JS: In terms of the global macro CTA world, the very [large returns] you don’t see anymore. Smart money is a bigger percent of the pie, so it becomes a lot harder. The scope of what is possible is not as great as it was. Markets are always changing. Currency markets were hardly a factor back then. Hedge funds as a whole were much smaller, but the general principles of trading haven’t changed.