Imagine that a star fund manager, with nearly a decade of stunning results, decides to completely retool the way that he does things.
Would you think that he’s crazy? Would you call him a has-been?
Or would you draw a different, more instructive lesson—that this is the reason why he’s stayed a top fund manager?
The FT recently ran a story about Pierre Lagrange, a well-known and extremely successful hedge fund manager in London. Famously the “L” of the prestigious fund GLG, he runs a $2 billion long/short equities fund. He admits to being stung by the 2008 crisis, in which his fund fell nearly 20%. For a long/short fund which is supposed to deliver smooth and generally positive returns, this was a big wake-up call, leading to him making substantial changes. By being willing to retool everything, he has gone on to achieve great returns since then —with very little accompanying risk.
In the interview, Mr. LaGrange talks about the lessons that he himself has learned over the last couple of years. Aided by some new analytics, he has been able to fine-tune his strategy and to capitalize better on what he does well, while doing less of what he doesn’t do well.
Lesson #1: Know where you make your money and where you don’t
With the help of a new addition, he has figured out where he makes money and doesn’t. First of all, he concluded that “betting on the direction of the market was not his forte”, meaning that he was either losing or not making money on big directional bets. For instance, in the big sell-off of 2008, the fund lost 7% because of directional bets, i.e. betting that the market would go up when it in fact went down. For a fund that is supposed to be generally agnostic to market movements, this meant that they were losing money on something that they weren’t supposed to be doing in the first place—and that they weren’t actually very good at it. As he puts it in the article, “It’s a shocker how much one doesn’t know about oneself as an investor”.
On the one hand, this has served him well. Given that markets have recently been driven by politics and central bank policies, it has been much more difficult to make directional bets with any conviction. Furthermore, without a real defined trend in most equity markets over the last couple of years, there hasn’t been much money to be made in directional trades. If anything, the volatility within broader ranges would probably have been a drag on returns.
Rather, he decided that they were making most of their money on individual stock picks made by their research analysts, who focus on individual sectors. They are the true specialists on their respective industries, and use their specialist knowledge to generate performance. As Lagrange summarizes it, “We’re good at stockpicking, so let’s just focus on that”. Amen. Stick to what you’re good at!
To exploit this edge, Lagrange shifted the strategy even more explicitly towards having longs and shorts, while he manages the overall risk of the portfolio. Thus, the individual research analysts get to decide which stocks to buy or sell, sometimes overruling Lagrange, but he gets to set the overall risk parameters within which they operate. But that leaves more of the portfolio in the hands of the analysts, leading to better returns, while Lagrange gets to be more of a coach. As puts it bluntly, “he just allocates the risk budget”. But if you’re good at managing the risk budget and that allows your analysts to focus on what they are good at it—then why not do more of it?
Lesson #2: It’s not just about being right
Most people think that making money in the markets is all about being right on as many positions or stock picks as possible. The closest comparison would be a test—you want as many right answers as possible or else your score will suffer. Unfortunately, this is a bit simplistic and wrong. What matters is your overall statistical expectation on each bet—that is, how much you make on your winners and how much you lose on your losers, in the context of your overall win rate.
For the purposes of simplification, imagine that you make ten times your money on each winning trade and lose only your bet on each losing trade. You could sustain a win rate of only 20% and still make good money over the medium to long term. Thus, the key is to make sure that your win rate, along with the ratio of win size to loss size, is such that you can make good money and avoid catastrophic drawdowns.
One of the Lagrange’s big surprises was that their stock picks were right between 45-65% of the time—not a stellar win rate but ok. However, they made an average of 1.1-1.2 times as much on the right picks as they lost on the bad picks. When your winners are bigger than your losers, then statistical expectation starts working in your favor—even at lower than a 50% win rate, you can still make money. At 60% win rate, which is within their estimated range, then the team makes tons of money.
Furthermore, just by tweaking a couple of factors, you can substantially increase your profitability. In the interview, the team mentioned that it was trying to let its winners ride for longer while cutting losses sooner. If they can keep the batting average the same while moving the winner:loser ratio higher, say to 1.3, then that would be a substantial boost to profits.
As we have discussed in the past, “4 Quick Ways To Get Better At Trading” and “How to Bounce Back From Failure in Trading”, the ways to get better at trading often involve a series of minor tweaks, rather than huge, sweeping changes. For instance, instead of trying to hit the ball out of the park on every trade, just study your records a bit more and try to tease out where you could increase your winner:loser ratio just a bit—as over time, that will result in a material change Or identify one entry setup that has a subpar win rate and just stop taking those trades—that should boost your win rate by a couple of points but it would also mean a boost to your overall profitability. Know yourself, study your records and make the small, incremental changes that will boost your profitability substantially.
Lesson #3: Be willing to make changes
The key reason why Lagrange is back to doing well and still managing $2 billion is precisely because he is willing to make changes. Without making changes and evolving as an investor, you will never be able to reach the profitability that you want—either because you will never be the best that your talents allow you to be, or because you will fail to keep up with the opportunities that come from changing market conditions.
For instance, Lagrange generated good returns for several years because he took directional risk by running some outright longs. While it was riskier, in bull markets it does lead to higher returns. The flipside is that in bear markets, like 2008, the excess risk hurts him. By running a “flatter” book—i.e. taking less directional risk—he is able to take down the risk and better capitalize on the trend-less market conditions in the world. This also insures him against the random market movements that come from political and central bank announcements. While you could make money on those sharp moves, the risk just isn’t worth the hassle.
Ultimately, this is the mindset of a champion. A winner is willing to rethink what he is doing to make it the best possible. Famously, Tiger Woods had a swing coach and completely retooled his swing many times through his career. Nolan Ryan, one of the most famous fastball-throwing pitchers ever, developed a new pitch and improved his control and went on to enjoy a long and successful career.
Similarly, great traders are willing to make changes in their game and retool. Lagrange and his team evaluated what they were doing wrong and doing right. After they had analyzed it, they consciously shifted their strategy to take advantage of their strengths and minimize their weaknesses. Their success is the product of understanding their results and then being willing to make the necessary changes to keep winning.
Success is not just a place where we get to and then rest comfortably. Given constantly changing markets, that’s impossible for traders. Rather, success and mastery are the process of continually changing and growing in order to meet new and shifting challenges.
It’s this willingness to learn and change that explains why LaGrange is worth $500 million and remains at the top of his game.
No relevant positions
By Bruce Bower | E-mail: Bruce [at] howoftrading.com
Blog: www.howoftrading.com | Twitter: @HowOfTrading