Jack Schwager began his career in markets as a research director for Paine Webber looking into the emerging commodity trading advisor (CTA) universe. His research and writing skills led him to write several technical trading books. But he longed to learn more about what makes successful traders than can be found from a quantitative study and decided to go right to the source by interviewing the most successful traders of the day. Schwager has gone beyond simply telling the stories of successful traders. His knowledge of the space landed him a position as co-portfolio manager for ADM Investor Services’ Diversified Strategies Fund and he has consulted for institutional investors for many years. His early “Market Wizards” not only told the compelling stories of successful traders, but also served as inspiration to a generation of new traders, many of whom have taken their place in the roster of market wizards inspired by the stories in the original books. His newest book, “Market Sense and Nonsense,” attempts to debunk many of the misconceptions in the investment world. We talk to Schwager about what he has learned interviewing traders over the years.
Futures Magazine: Jack, you have had a long distinguished career in finance but are best known for your "Market Wizards" series of books. What drew you to interview successful traders?
Jack Schwager: The idea came years before the first "Market Wizards" book. I thought it would be a good way to meet these people and it was an interesting project, but I had a day job and I wasn’t about to start another book. But I was approached by [a publisher] who said, 'We would like to do a series of books and I want you to be the managing editor.' They wanted me to do a bunch of analytical books, and I said, 'Thanks, but no thanks. I’ve done my analytical book, but I have this idea [for a book on traders].' They said that’s great so that was the catalyst.
FM: There are a lot of successful traders, how do you decide who you will include in your books? Are there any set criteria you use for inclusion?
JS: The first two books I was looking for a spectacular story. And there were quite a number of those around at the time. Those were in the days where you had (Michael) Marcus, (Bruce) Kovner and Paul Tudor Jones, and it was early in their careers. They were not very well known yet [and] had these spectacular track records. That is what I was looking for in those early books. Right now I am not so much focused on returns, I am looking at return-to-risk as a guideline. So it could be someone with good returns or somebody who only earns 10% — a fund like BlueCrest, the flagship fund has returned 14% or so since inception, that is good, it is not eye popping. Bt what I consider spectacular is that he did it with a max drawdown under 5%. My focus is really on return-to-risk.
FM: In a sense, did the series evolve along with your knowledge of investing?
JS: I have evolved to where I never look at returns in isolation. The only way I look at returns is with some normalizing risk factor. It is all the more critical in the CTA space where everything can be notionalized. The only measure really is return-to-risk.
FM: Any second thoughts on profiles?
JS: Oh sure, I have made mistakes. But mistakes would not be someone like Richard [Dennis], who subsequently had less successful careers. Dennis started with less than $1,000 and turned it into $200 million, I don’t really care what happened after that point, that is an accomplishment only a handful of people in the world will ever [achieve]. That was the story. However, I did have people in the books who did do well whose returns I thought were not dependent on the bull market. But at the culmination of the bull market, returns disappeared. So, in retrospect their returns where dependent on the bull market. So I am not happy with everyone I picked.
FM: Are there certain qualities that you have noticed successful traders tend to have? What are they?
JS: There are. It is always hard to pick which ones are most important. One that is most often mentioned by traders themselves and is a bit of a cliché is discipline. But it is true, all these successful traders are disciplined. Discipline is absolutely essential. Another one high on the list is extreme flexibility and the ability to change your opinion. The really good traders can be wrong on a trade and not only just get out but also reverse on a dime.
There are all sorts of examples but the classic of all time would be [Stanley] Druckenmiller who on Friday Oct. 16 of 1987 had been short the market and decided [to get out]. At that time he decided the market had gone down enough and covered his entire short position and [went] long, which is probably the worst trading mistake anyone made. And he came out of October ‘87 with only a small loss and the reason is — of course he made money in the first half of the month — he decided over the weekend that he made a mistake and came in Monday morning with the conviction that he was going to get out of his long position, unfortunately for him the market gapped lower so what did he do, he not only covered it at the first instant but turned around and got short. I don’t know of any better story of extreme flexibility.
The single most important thing, even before discipline and flexibility, is that they evolve a trading methodology that fits who they are. You see all sorts of different types of approaches. Take Jim Rogers who believes in fundamentals, who deals with long-term trends, who is really good at calling these long-term trends and staying with them, who doesn’t believe in technical analysis. So for him, a long-term fundamental player, that works well. And then you have somebody like [Ed] Seykota — or any of the other technical guys — that has a completely opposite view, and they don’t want to know the fundamentals, they just want the prices and that works for them. You have to know who you are. You also have to know if you are short-term or long-term, you have to know if you want to be concentrated or diversified, if you want to take a small risk per trader or a wider risk, on and on and on. Every person has a different approached [based on] who they are and if they try and trade something that doesn’t fit [with who they are] they will go off the rails.
FM: How difficult is it to write about alternative investment traders for a general audience more familiar with traditional investments?
JS: It is unique and it is not unique. Trading is a broader scope. I would draw the line between investing and trading. Trading stocks and trading futures overlaps a lot. Take some of the stock guys in the book. They might use fundamentals that don’t apply to futures, but the way they might integrate fundamentals in risk management is just a different way of doing it but in the same spirit as a futures trader.
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.
FM: Haven’t the expectations changed? Managers aren’t shooting for huge returns like they used to.
JS: What is possible has gone down, [especially] with the zero interest rate environment. If you have 6% or 7% interest, that adds to your return. So the zero interest rate counts against your return. You look at the long-term trend followers who have been around for a while, those that started in the 70s and 80s and even early 90s they had one type of return and then if you look from the mid-90s on it has been a different story. Trend following still works but it certainly doesn’t deliver the return to risk as it did in the early days.
FM: You most often write about hedge funds and CTAs, do you consider managed futures a hedge fund subset or a completely different asset class?
JS: I consider it kind of a subset, but there are some very important distinctions. One of them is liquidity. It is the most liquid part of the investment universe. That also means something else very important. It means that CTAs are the only group that is probably immune from the correlations going to 1. At the end of 2008 you had all these strategies, which at times might be significantly uncorrelated yet during the crisis of 2008 and 2009 start to behave extremely similarly. That is true because everybody is on the same side of the fence; everyone is trying to get out. However, CTAs by virtue of the ability to get out of any position on the same day and as importantly go short, they are not vulnerable to the losses [related to] correlations going to 1; and in fact they may be in a situation to take advantage of those factors. If they are smart and good, they can not only not be long but they can be short and make some money out of that crisis.
FM: The CTA space has become more institutional. Managers are shooting for 10% instead of 50%. Is this a good thing?
JS: What a manager targets is totally irrelevant. I say that as an allocator. I don’t care if a manager is targeting 5%, 10%, 20%, 40% whatever. Why? Because you can take a guy who is targeting 5% and then decides he is going to target 40% and his risk goes up by a factor of 8. That’s fine; I’ll just invest one eighth, so it is irrelevant. If you invest in a managed account you are going to decide what notionalization you are going to use.
FM: Your new book attempts to debunk the Efficient Market Hypothesis — for those who still subscribe to it. Why do you think this has persisted despite all the evidence to the contrary?
JS: That is easy to answer. Because the efficient market hypothesis and underlying assumption of normal distributions and so forth, the whole academic finance structure, there is one great thing about it. It allows you to quantify, it allows you to give precise answers. It may be the wrong answer but it is precise. If you take away that normal distribution and that markets are efficient, then you can’t really answer the questions: ‘How do I allocate my portfolio? What percent should I put in stock and bonds? What is my best allocation?’ You can’t answer that question, but you can answer it exactly if you use portfolio optimization, which assumes a normal distribution. I would argue that the answer is not only wrong, but it may be worse than random. People like it because you can quantify and give pat answers. It allows for definitive conclusions. My view of markets is that they are influenced by fundamentals and there are times when the markets will act [efficiently], but the really big moves come where emotions play a very large role. We call those big moves bubbles and the collapse of bubbles. That model describes the world accurately but as I like to say: market moves begin on fundamentals and end on emotion. The only [problem] with that is there is no way of quantifying emotion. The Nasdaq stops at 5,000 plus, it should never have gone to 5,000 plus and it could have just as easily stopped at 4,000 plus and still have been way overbought or it could have gone to 6,000 or 7,000. [The Efficient Market Hypothesis] may be the correct way to explain the world, but it does not allow a way to define how far is too far. There is a large amount of chaos and randomness to it.
FM: I have profiled many managers who cite your books as the reason they became interested in trading. What do you think when a manager you are interviewing tells you he was inspired by a profile from one of your books?
JS: This may sound a bit self-serving, [but] almost everyone I interview cites my books. It is extremely common for managers I interview to tell me that my books got them involved [in trading]. Quite often they talk to me because my books got them interested so they feel some sort of an obligation even though they have no reason to. In "Hedge Fund Market Wizards" I actually had the problem that my books came up so often in interviews that I became self-conscious of the material. I decided to take out the reference if I didn’t think it was necessary.
FM: What is your opinion of the trend toward manage futures funds? Do you see this moving to a point where it will be normal for retail investors to have an allocation to trend following strategies in their portfolios?
JS: I have mixed feelings. On the positive side it is preposterous to think that mutual funds of stocks are OK for regular people and conservative investments whereas mutual funds of CTAs are risky and shouldn’t be allowed for average investors. It is absurd because if you go by track records, returns are probably similar and they are much less volatile and risky in the CTA world. There is a complete bias unsubstantiated by any [analysis] and that flies in the face empirical evidence. So there is a reason why mutual funds of CTAs should be perfectly fine and provide diversification. All of those reasons [show managed futures] are absolutely a legitimate product and everyone should have it in their portfolio. However, here is the problem. If too much of this goes on, the traditional investment world is too large and the industry can’t absorb it. If it becomes successful, it is going to kill the industry. Returns will be driven down where there just won’t be satisfactory returns. The biggest risk to the industry is if it becomes too popular.
FM: But most of the allocations to managed futures are concentrated in a few institutional managers, like Winton. Isn’t there a lot of capacity in emerging and non-institutional CTAs?
JS: Yes, that’s an old problem. I consult as a portfolio manager and the managers I recommend are smaller managers. We have very few large managers. Ironically, the one large manager we have has by far been our worst performer. You’re better off [investing] in smaller managers. It is very difficult for these giants to deliver great returns to risk. Also, a lot of the big guys are very correlated. So for those reasons, I personally gravitate away from the larger managers.
FM: After two tough years for CTAs, we are hearing once again that trend-following is dead. This is the third time since I have been following CTAs that I’ve heard this. Do you think the markets have changed in a material way or has it just been a poor environment that will change because everything in trading changes?
JS: The markets have changed. You have a tremendous amount — a much larger amount — of money using trend-following techniques than what was the case earlier. The fact that there is so much money in this strategy inevitably hurts returns. That makes trend-following more difficult. However, there are some very strong fundamental reasons why trends should exist. The key reason is the way markets fundamentally work. Central banks may make major policy changes. You get those all the time; countries make major changes in financial policy that will change the direction of interest rates and currencies. Those policy changes that are supported by action will cause trends and will cause trends to persist. Commodities aren’t [affected] by government as much but you have surpluses that cause mines to close down and with the lag; world demand then goes up. Supplies are not increasing so that surplus creates a new shortage and starts a new process so you get these cycles in commodities where the actions to rectify extremes can only be affected with a lag; so you get trends. However, if too many people are trying to exploit those trends then those trends become much choppier. It doesn’t make those trends disappear but it makes them much more difficult to capture.
FM: A point I have made over the years is that trend-following is a pretty broad description of a group of approaches used to find an edge in futures markets and there is more diversity in that space than many people realize. Do you agree?
JS: Actually, I would almost disagree. If you look at different strategies, one of the strategies that has the most correlation among managers is trend-following. Trend-followers as a group, correlate with each other in bull markets, bear markets, sideways markets; year-in, year-out there is a much more stable correlation. If you took some other strategy like merger arb or convertible arb and look at them, there will be periods where they will be correlated to each other and periods when they [aren’t as correlated]. But with trend-followers the correlation is very stable. There is some diversification there but not a ton so what I would consider for example in my portfolio is I don’t want all trend followers or most trend followers because it would kill diversification. But I have a certain segment of trend-followers and within those trend-followers I am looking at for doing qualitatively different things to capture the trend. When I look at the average pair correlation if it is something like 0.4-0.5 that is still significantly correlated but it is a lot better than 0.7 or 0.8 so you can find managers who are doing things differently.
FM: There is a tendency in professional investing to try and benchmark everything and set a beta for various types of investments. While there are better and worse environments for various strategies, this approach tends to eliminate qualitative differences among managers. Is this a mistake?
JS: The CTA space becomes much more differentiated as people like myself look to find strategies that are uncorrelated to trend-following. It has become much more differentiated and there are a lot of strategies out there other than trend-following. In my own portfolio I make up my own sub-categories: Fundamental systematic, trend-following, fundamental discretionary, technical discretionary spreads, mean reversion, intraday, systematic vol arb, pattern recognition, short-term systematic; all of those are different from trend-following.
FM: How has your profession investments performed?
JS: I have a number of projects. The main one right now is acting as a portfolio manager for ADM [Investor Services Diversified Strategies Fund]. I don’t talk about returns, and we just started in the middle of last year. It is basically a fund of managed accounts of futures or FX managers. The number is in the 20s and the allocation process is risk based.
FM: What is your ideal portfolio allocation?
JS: I guess that would change over any given period of time. A diversified portfolio of CTAs should be a good part of it. A good sum of it should include some hedge fund investments, and if you wait for periods where equity markets have drawdowns, establishing long positions in equities would be OK but not after a [strong up move].
FM: You wouldn’t have a certain percentage always dedicated to equities?
JS: No, I don’t believe in having a certain percentage [permanently] allocated to equities. I believe in allocating to equities when they are doing terrible and allocating to CTAs/hedge funds [strategically]. I certainly don’t believe in any balanced portfolio type of mechanism or guideline. That could be dangerous. Any investment I might have [right now] would not have a long fixed income element. I could be wrong but from a long-term return to risk, there is much more risk than return in being long [bonds] than being short or flat. While it is traditional to have 40% of your portfolio in bonds, it could be a very bad thing to have. That falls under the realm of a market forecast; let me make clear that I don’t consider myself a market wizard.