Before I get into today’s subject, some very tragic news for our industry last week as I understand that Steve Jennions, former FX trader at Citi, Morgan Stanley and Deutsche Bank to name just three firms, died last week. I only met Steve once to my memory, when he was at Morgan Stanley, but talk to people who knew him well and you hear about a real character in our industry – and a good trader. My condolences to his family and friends.
I have no wish to build a trite link between such a tragic incident and the subject of this column but traders like Steve Jennions, who spent a fair chunk of his career in prop trading, might actually understand where I am coming from today, because they understand the need to evolve – markets do not stand still, and nor does participant behaviour. To be successful as a trader you not only have to move with the times, but you also have to find an edge – and sometimes that takes you into strange territory.
Take markets at the moment, they are becoming dominated by machines and systematic processes. Passive investing is easily the most successful investment strategy in terms of asset growth, and, of course, it’s proving pretty successful in terms of performance – why wouldn’t it when inflows provide an instant boost to performance? There is still a good case, of course, for the “buy and hold” approach to markets, but what happens if the drawdowns get serious – especially in an age in which everything is judged over shorter and shorter time horizons?
A friend sent me an interesting interview with Man Group CEO Luke Ellis in the Financial Times in which he observes that the age of the “star trader” has gone – and will not return. Ellis was talking about the ego of the star trader rather than their approach to markets, and he was saying, rightly, that the hedge fund should be about the client and not about the manager. He also thought that successful managers will probably be those managing smaller pools of money than previously (I think we’re probably still talking some sizeable sums of course).
I have argued before, in these pages and in the podcast, that there is a downside to managers getting too big – and we have had some high profile examples of hedge funds effectively being forced to return money to investors because the market environment did not suit their style of trading when it was allied to the size of the money under management. The problem is we are obsessed with making the big bigger in the current financial world, because the analysis that underpins so many investment decisions looks only at the data – so it becomes, to a degree, self-fulfilling. This lack of imagination sends the vast majority of investors down a relatively small track and, thankfully for everyone concerned, the throng of people entering the strategy on a weekly basis maintains the momentum of those at the front.
They thing is, trends and cycles do break in financial markets, and when they do we need the kind of people that think a little differently; are unafraid to step off the track; and, most importantly, are nimble enough to get out of the way of the reversing steamroller. In a way this is the star trader that Man’s Ellis was talking about – but hopefully without the public trappings of wealth attached. Whatever it is, it involves people thinking differently, the way a prop or hedge fund trader would.
The other – linked – trend in financial markets is automation. There is more computerised trading, and while specific data is not easy to track down, there is a sense that computers are making more decisions than ever before across all aspects of markets – after all, why do people get so excited about AI if it’s not going to be making a few important decisions?
The hedge fund industry has been suffering of late. Liquidity in a few important markets has dried up for the big firms, performance has been OK but probably underwhelming, and the rise of passive investing has eaten into what was, for a decade or two, a really impressive growth track. I know industry bodies talk of higher AUM for the industry, but compared to how other strategies, like the index trackers, are growing, it’s lagging – and it’s doing so at the very time you would expect investors to be looking at these alternative, non-correlated investment channels.
Which, finally, brings me to the rather controversial point of this piece. How will the next generation of hedge fund manager cope with such a challenging environment? More pertinently, how long will it be before some traders in the world start trying to play games with the machines? This won’t happen in the risk-averse, conduct-obsessed, banking world, but in the world of hedge funds trying to find an edge, I wonder how long before someone starts devising a strategy that can identify weak points in a trend (a clue: they’re close to the top and bottom!) and then trade aggressively to trigger a break out?
It’s not easy, and to some it may not be ethical, but I cannot believe someone out there isn’t thinking about how such a strategy would work. It would involve significant risk, which is difficult for many to accept in the current risk-averse world (investors like a world in which the S&P just goes up and earns them nice money), but it could work. The ethics of the strategy may be open to question, but I look at markets that trade without last look-style mechanisms and I see the firm trying out such a ruse having to trade. I want to stress I am not talking spoofing here, I am talking about a firm who sees what they believe to be an over-stretched market and they hit it hard, with real cash, and trigger a correction – or maybe they don’t, that’s where the risk lies.
This need not be a bad thing for markets, it could be argued that the longer a market trades without a correction the bigger the wipe out will be when it does, inevitably, come. In reality if there are more regular corrections then who knows what it will do for the markets, but it is also interesting to note what it would do to the machines and their decision making. As a fan of automation, one thing bothers me and that is how the machines deal in data, and enough data becomes self-fulfilling. The rational is overlooked, the fundamentals ignored – does that sound familiar to market watchers at the moment?
When a prolonged upmove comes to an end it could be horrible – central banks don’t have a great deal of weaponry left in the armoury – but I think if the data-obsessed, machine-driven investment strategies were challenged a little more often, then the market may actually become a more healthy place. After all, we all know that when the market starts going down, the same decision making process that has driven the upswing will extend the downtrend.
This is why we need prop traders and hedge fund managers, people willing to look outside the box and challenge the status quo. If it doesn’t happen, and the world continues on its very happy path of multi-digit returns in spite of what the fundamentals may say, when the inevitable correction, that everyone knows is going to come at some time but will not challenge the all-important data, actually comes, and there is a real wipe out, and we all look for someone to blame, there won’t be anyone beyond a few servers.
So yes, this whole column has been (again!) about the need for risk in the world to help it achieve balance. It is particularly poignant that I have written this whilst at the same time mourning someone who, I think, would have totally understood the point I am trying to make. RIP Steve Jennions.