SAC, the infamous hedge fund led by mercurial, secretive, super art collector Stevie Cohen is legendary. They have recently been accused of insider trading and it sure looks like they are guilty. But there are a lot of very smart people that worked there that had nothing to do with this scandal. PMs and analysts in Hedgistan dream of toiling there and making obscene riches. As an unabashed trading addict and player of The Game, I was like a moth to the flame. I had to check this place out. I did. Although by dumb luck and a well-calibrated BS detector, I was able to avoid joining them, I did meet with them over a dozen times. I learned some principles that have changed my way of trading forever. For the good. Out of a spirit of equanimity and gratitude, I will share them with you.
1. RULE ONE: IDEA VELOCITY. This is so important and it will seem so obvious after I tell you that you will wonder why no one talks about it. Let’s do some math. Let’s say you’re a long-short PM and you typically have 15 longs and 8 shorts at any given time. Call it 25 positions. If your average holding period is 6 months because your portfolio turns over twice a year, which is fairly typical for an actively managed stock fund, that means you need 50 positions per year. That is one high conviction idea per week! That doesn’t sound like all that much, but tell me, do you really have a discipline in place to come up with at least one, highly researched, well-thought out, high conviction idea per week? I’m not talking about being pitched a quick stock pick by the sell-side either. . In tech, things change fast, and sitting on winners that have stalled out too long is a mistake. It’s also called complacency. The only way to know these numbers, such as your average holding period, number of positions, is to analyze your trading records ruthlessly and honestly. This is the concept of IDEA VELOCITY.
2. POSITION SIZING. When you find an idea, a high conviction stock idea, how do you build your position? Do you scale in? Do you buy half and another half later after you see how the stock trades? This is what most investors do. TOTALLY WRONG. That’s right. If you have a high conviction, well-researched idea, what is the point in putting on only a half position? If your original position drops by 15%, what do you do, buy more? Does that make any sense? Or if it goes up after you buy it, yes, it makes sense to buy more, but didn’t you just lose the gains you would have had if you had the cojones to buy the whole position at once? Furthermore, what are you doing putting on a “half position” if you don’t have the conviction to put on a full position. So when you put on a position, do it all, at once, one day. POSITION SIZING- the key to good performance.
3. CASH IN THE PORTFOLIO. How much cash should you carry in your portfolio? Most PMs will play around with the amount of cash in their fund. Some even brag about how their performance for is all of the S&P upside while being only 65% invested, because they are holding 35% in cash. What kind of stupid logic is this? If I’m paying you 2 and 20 to invest my money, then invest it all! This is the key concept- INVEST IT ALL! If you are so good that you can get all of the S&P returns with 35% cash, then just give me the cash back so I don’t have to pay 2% on the cash. Let me make my own asset allocation decisions. So an equity long-short fund should be 100% long and some portion short. In SAC case, they would prefer PMs be no more than 15% net long, so that meant they would be 100% long and 85% short for example. I’m not advocating that. But I’m saying equity funds should not carry more than a minimal amount of cash. If you don’t have ideas for the money you’re managing, you need to re-read rule number one, IDEA VELOCITY.
4. SHORTING INDICES. Many fund managers think they are great stock pickers. Actually, we all do, by definition, because we are charging people for our great skills- otherwise they could cheaply invest in an unmanaged index. But these same managers decide they will pick the longs in the fund and then use an ETF to short against the longs, as a “hedge.” WTF kind of backward thinking is this? So you can pick what stocks will go up, and not the stocks that can go down? Does this make any sense? Then the clever among this group will argue with you that because the market goes up over time, it’s important to spend time on longs and “hedges always lose money.” NONSENSE. Even in a bull market there are stocks that are going down. (Do you need examples? IBM, “Big Blue,” the bluest of the blue chip techs, is down 8.5% as I write this, versus the NASDAQ up 33% for the year.) I’ll tell you what- if you want to play with indices, and you tell me the market goes up most of the time, I will suggest that you LONG the index and spend all your time finding individual name shorts instead. Did your brain just blow a fuse? Let me suggest the best approach and that is pick longs and shorts and never short an index. If you don’t have enough shorts, because “Shorting is hard” and all that, then go re-read RULE NUMBER ONE.
5. COLD STREAKS. SAC is ruthless, because they employ a lot of leverage. When one of their PM has a big drawdown, they tell them to slow down. This is the one case in which a PM will carry more cash. Or quite simply get some of their assets pulled from them. So let’s say you’re cold, your strategy and discipline is not currently working, and you need to cut back your positions. What do you do? TRADE SMALLER. So that means keep making new trades. Don’t freeze up. Did Jordan quit shooting when he got cold? So if you are going to cut your portfolio in half, say, to quell the bleeding, how do you do it? Most people will say, “well, I’ll cut my lowest conviction positions and keep the ones I really like.” Wait a minute- more stupid logic. What business do you have holding ANY low conviction positions? The right answer is you cut your entire portfolio in half, equally, across the board. If you have low conviction positions, you haven’t been following RULE ONE- IDEA VELOCITY.
So perhaps it’s obvious to you now how important the idea of IDEA VELOCITY is to a trader/investor. It’s the underpinning of everything in The Game. You have to work VERY HARD to come up with high conviction ideas every single week. The hours you have to put into this Game and the mental horsepower and the emotional toll are all much, much greater than most people realize. You can see why some of them wanted to cheat, to cut corners. This is a tough game. You know what? SAC didn’t need to cheat. If they all would have stuck with these principles, they would be thriving today. You can adopt these principles into your trading regimen and improve your performance.