The Front Office

Chapter 1: Common Misconceptions

I think I can say without fear of reasonable contradiction, that the hedge fund industry is the most hated industry in the world. It’s despised and envied by the press, thoughtlessly (often stupidly) caricatured in film and TV, and demonized by politicians on both the left and right, both large and small. It’s no industry to get into if you’re worried about being popular.

If you chose to enter it anyway, some people will wish you dead for no reason other than your career choice. You’ll get called a thief and a liar by people who have never met you. Entire political movements will exist for no purpose other than seeing you punished. For what specifically? They have no idea... but something. And though they’ll probably never think it through, they’ll still take the time to send you online death threats or to demand prison time for you on twitter, even when you’re strictly obeying the letter of every law and regulation.

With a few notable exceptions, hedge fund staffers and Bankers in general, are portrayed either as idiotic overgrown frat boys, high fiving each other as they steal money from widows and orphans, or as narcissistic deviants who get through their day consuming huge piles of cocaine, and their nights throwing parties filled with expensive hookers and dwarf tossing. This is nonsense. It’s nothing more than a dark, silly fantasy, created by screenwriters who have never been within 5 miles of a real hedge fund, and who don’t know the first thing about it.

Much of what you saw in “The Wolf of Wall Street” may have really happened. But while that sort of thing was going on at the seediest end of Wall Street, the most talented part of the hedge fund industry was hard at work at the other end. Institutional trading has as little in common with a bunch of nearly illiterate stock brokers scamming their retail clients, as driving a bus on the NJ Turnpike does with trying to win the Monaco Grand Prix. For most of the hedge fund industry this is deadly serious, deeply challenging work, from which a large portion of the general public derive an indirect benefit.

In the real world, you may read an occasional news story about some young hedge fund staffer whose party in a rented Hamptons house got out of control, or someone here or there accused of insider trading. That happens infrequently. But if you ask me, those stories are notable for their rarity. Any group of people as large as the hedge fund industry is bound to have a few bad apples. But it’s very uncommon because that’s not how the vast majority of the industry works.

There are plenty of people working in hedge funds who would do that sort of thing every weekend if they could. It’s no more a monastery than the Entertainment industry, or Silicon Valley. But the reason it doesn’t happen very often, is because for the most part it can’t. And that’s because of what the hedge fund industry really is.

What the hedge fund industry runs on more than anything else, is credibility. To be even moderately successful, you need to present a credible picture to the people in control of the largest pools of assets in the world. You need to persuade the people who manage those assets that you will protect their money from loss, while also presenting a careful, well-reasoned argument for why allowing you to manage it for them will result in greater profits.

You need to be in a position to demonstrate to them that those profits will be captured at a reduced risk, in all possible circumstances. And the kind of people who ski down piles of cocaine with a hooker under one arm and a Velcro clad dwarf under the other, don’t generally present an image of the most intelligent, careful, prudent decision makers to the people who control the entire wealth of the world.

I wrote that last sentence knowing full well that most people won’t really understand what I mean by it, because in order to do so, they need to adjust their frame of reference. When I say ‘intelligent, careful and prudent’, you need to imagine a new paradigm. You need to imagine the most careful, most prudent, most emotionally steady person you know, and then multiply that by 1,000. Imagine that they’re also a genius, because a huge percentage of people in the industry are.

Imagine a much smarter version of Robert Duvall in the “Apocalypse Now” beach scene with mortars going off all around him, while calmly discussing the break of the waves using computational fluid dynamics that he’s calculated in his head. Imagine him scratching out the differential math in the beach sand. That’s a better analogy for the actual day to day in the hedge fund world.

If you’re on the quant side, (and these days there are plenty of reasons you should be) you need to be brilliant. Everyone in the quant hedge fund industry is brilliant – you can’t get into it otherwise. But more than that, you need to be steady and reliable. That’s the image you need to project when you’re running a hedge fund, and the reality of what’s going on behind the scenes should come as close to that as you can manage given your individual disposition.

But if you really want to understand what the day to day hedge fund world is like, the best analogy I can think of is this. More than anything else, the hedge fund industry, and in particular the quantitative hedge fund industry, is similar to a professional sports league for smart people.

Lots of people claim to be smart. Lots of them actually are smart. But smart is a relative term.

You may call yourself a good tennis player. You can beat everyone you know. You can beat everyone at your club, or everyone at your all city league. You might even be a ranked amateur player, which would make you very good indeed. But you’re still gonna get your clock cleaned in straight sets by an unknown 15-year-old Serbian kid in the first round at Wimbledon. That’s what the quant hedge fund industry is like. It’s Wimbledon for smart people. And it’s like that all the time, every single day.

There are no winning stories in sports. The results don't change because the losing team had a really good excuse. And there are no rule changes once the game has begun. At that point, you either win or lose on the field, and the numbers on the scoreboard tell the totality of the story. It’s the same in trading and the hedge fund world, but the numbers are at the bottom of the page. It doesn’t matter if one team or the other says they were better or smarter. All that matters, is how they did on that day.

The main reason credibility matters so much, is because in trading, just being smart isn’t enough. Not anymore. When I first arrived on the JPMorgan trading floor as a quant back in the 1990's, being much smarter than anyone else was probably good enough on its own. I know this because that’s just about all I brought to the table. I had no lofty credentials, no family connections and no friends in high places. All I had was a very sharp mind, a fanatical work ethic, and an emotionally unhealthy desire to sacrifice anything I had to, in order to prove I could be as good as anyone else, regardless of background. But things have changed since 1992. Lots of things. And they’ve changed in important ways.

And of course, many things haven’t changed. The finance industry is still run by people, and people are still (let’s be generous) imperfect creatures. That’s why credibility not intelligence is still the primary barrier to entry.

The people at every level of the investment management industry are still shallow, vain, selfish, insecure, egotistical, grasping, occasionally greedy people like the rest of us. No one, and this includes every level, especially the investors, are in it for the nobility of helping others or promoting some vaguely defined social good. They all have charities for that. Every decision they make, including what they have for lunch or what car they drive, they do to protect and increase the quantity of money.

Think of it this way. Who do you know that you would lend $20,000 dollars to? Twenty grand is a lot of money for most people. You might lend it to a family member. Since they’re family, you might even lend it to them with the knowledge that you’re probably never going to get it back. You might lend it to a friend from college who has some history of success. But the person you’ll most likely lend that kind of money to, is someone who has a clear plan, a good track record, carefully written and legally enforceable contracts, and who doesn’t really need the money from you because they can get it from anyone. It’s the same paradigm in the hedge fund industry, but with more zeroes in front of the decimal.

Sure, to some people twenty grand isn’t a lot of money. Maybe someone like that who had a Kennedy or a middle eastern prince as their roommate at Harvard or Eaton will start what they call a hedge fund based solely on connections. That Kennedy or middle eastern prince may start their own hedge fund with family money. That happens all the time.

But what they’re doing isn’t really running a hedge fund - not one that needs to be competitive anyway. With connections like those, they don’t need to be smart. They also don’t need to succeed. All they have to do is avoid doing anything too obviously stupid and losing a fortune. And even if they do, chances are, the person who gave them money to manage in the first place has taken that into account, and kept most of their money out of their irresponsible hands.

But for people like you or me who make up the majority of the people in the hedge fund industry, there will be no such easy road. Is that unfair? Probably, yeah. But that’s the way it is, so you had better get used to it. If you’re looking for fairness, go someplace else. (And when you get there send me a note because I’ve been looking for it too.)

OK, so there are people in the hedge fund industry who in a fair world, don’t deserve to be there. Nothing is perfect – fair enough. Thanks to objective performance metrics, they’re probably viewed as being at the bottom of the pack. The cutoff between a mid-sized hedge fund and a small one is probably about 1.5 Billion AUM, so that should give you a sense of scale. It’s not unheard of for someone getting by exclusively on connections to grow larger than that, but it’s rare.

But what about the other people? What is there to learn from the guys who didn’t make it on connections? What about guys like Billionaire Bruce Kovner who drove a cab before he started trading. What about legends like Paul Tudor Jones, or Louis Bacon, or Izzie Englander? What can we learn from knowing what they know? Do they have some secret? Some special insight that got them to the top? The short answer is a qualified ‘yes’. At one point or another I worked for most of those men, so you’ll find some of the things that they have in common in these pages.

But don’t expect too literal an instruction. After all, if following in someone else’s exact footsteps were an instant path to success, then it would be a very crowded path indeed. What for instance would stop all the other people who are already in the hedge fund industry from simply doing exactly what those guys did? If something like that were going to work, at a minimum you’ll be in line behind a lot of other people. And one of the things those Billionaires would be the very first to tell you is that no one gets to that level of success, by standing in any line.

Remember, your goal is credibility. What you want in the end, is to be in a position to walk into a room full of pension fund allocators and billionaire CEO’s who control hundreds of billions of dollars, tell them how you’re going to make them a huge profit at very little risk, and have them believe you. These guys are lied to every single day of their lives by people looking to get money from them, so they’ve heard it all. More, it’s safe to say, than you can possibly dream up on your own. Generating sincere belief in those men and women is probably the hardest part of the job – almost harder than generating the profit itself.

Not that generating the profit is easy. And to complicate things, generating a big profit isn’t really the goal - not in the hedge fund world. The goal, the actual goal, is generating a huge profit without taking on a huge risk. You might not believe that at this point, but I’ll explain why it’s true. And actually, for you, it’s even harder than that. What you have to do is generate a huge profit without taking on a huge risk, and without doing it the same way that everyone else is doing it.

If you go buy the S&P 500 and wait 5 years to sell, you will in all likelihood generate a substantial profit. Depending on the year you start, you might do better than the hedge fund industry average. But no one is going to pay you comparatively high hedge fund fees to do something that they can do themselves for free on Robin Hood.

So how do the big guys think about it? I’m going to tell you. But explaining that is a tricky thing because the language of finance is so cryptic to the uninitiated – and the language of quantitative finance, doubly so. Any description that doesn’t involve using formulas is a mish mash of repurposed words from English and Greek, all of which are very easily misunderstood unless you have a solid foundation in statistics and probability. Even if you do, thanks to fat tailed distributions, the differences get complicated very quickly and the meaning of the numbers are very easily misinterpreted.

The descriptions are also painfully circular. Everything in the markets is connected to everything else, so there is no origin point to start from that doesn’t already depend on a minimal understanding of all the other parts. You try describing an elephant to a bunch of blind men who are all absolutely certain that it’s really a tree or a snake. For the uninitiated, a great many of the things that people are sure they understand, all actually stand in the way of explaining how it really works to them.

Do you have any idea what a ‘variable leg cash flow for a forward-forward rate’ is? Do you know why I said ‘forward’ twice? Can you figure out what kind of instrument it refers to or how to begin to value it? If so, you’re well ahead of the game, and probably have some real financial training. If you don’t know, then you should at a minimum be willing to recognize that there’s a bit more to market finance than you presently understand. Being able to admit to yourself what you do and don’t know, and that it might not be all you need to know, is one thing that definitely separates the successful from the unsuccessful in the hedge fund world.

I’ll tell you one secret that all of those billionaires all share right now – one I know they’d happily admit if anyone had the nerve to ask them. Go ask any of them who the smartest person in their firm is. I’ll bet you the 20 grand I mentioned earlier, that not one of them will say it’s themselves. If they had their way, they’d never hire anyone who wasn’t smarter than them. Being smarter definitely isn’t the answer, and every one of them knows it. Knowing the limits of what being smarter than everyone else gives you, comes a lot closer to the right answer.

Complicating the explanation further are the industry terms which have a clear meaning in one context and a completely different meaning in another. And these can be some surprisingly common terms. What, for instance is a trader, or for that matter, what is a trade exactly? You probably think you know what both of those are, and you may be right. But in the hedge fund world, both of those words are used in a much more specific context, and can mean totally different things when speaking to different groups of people.

A journalist might call me a trader, but no one in the top tier of the hedge fund world would. In the industry, my title was Portfolio Manager or when my title was Head of Equity Trading and I was hiring Portfolio Managers, my vocation was described as Risk Manager. A Portfolio Manager doesn’t trade. What they do is open or close positions. It’s a guy who’s working for a PM that does the actual trading, and most of the time, a computer algorithm does all the trading for him. All he really does is manage the exceptions.

Terminology errors like these aren’t yours alone. The industry has a whole bunch of words - not inconsequential words mind you, but words that are central to the entire investment process - that it can’t decide on literal meanings for at all.

Liquidity, for instance, is a word that’s at the center of virtually every question in quant finance. Yet in an industry populated by some of the greatest mathematical minds in human history, no one can give you a mathematical definition for it.

Floor brokers describe liquidity one way, banks describe it another, the biggest hedge funds describe it in a third, and the people on the retail side have never even heard of it or don’t care about it if they have. This makes those of us who try to come up with universal descriptions seem annoyingly pedantic and circular in our reasoning. If it helps, we find it as frustrating as you probably do.

But if there is a single (totally forgivable) mistake made by virtually everyone looking to break into the hedge fund industry from the outside, it’s this. They vastly, radically underestimate the intelligence, determination, work ethic, insight, creativity, and courage of the competition. To people on the outside it looks like an easy job. Write some code, turn it on and poof … you’re driving a Lambo. The truth of the industry is almost exactly the opposite.

When the unofficial industry motto is “We only eat what we kill”, you have to believe that they take their business very seriously. When the bell rings at the end of the day, they want the money that started out in your pocket, to end up in theirs. And the leaders have a very good track record of making that happen, even though they’re competing with all the same geniuses in the rest of the industry that you are.

The hedge fund industry is the deep water – the big pond. From the first moment you dip your toe, there are predators large and small in every direction, all the time. They are mostly faster than you, smarter than you, have access to far more resources, and probably know more about what you’re trying to accomplish and the weaknesses of doing it that way than you’ve ever imagined.

But they aren’t infallible. Quite the contrary. They’re much smarter than average but they’re much more arrogant too. They operate on assumptions which may or may not be true, and that most of them never even bother to question. They may do most of the same things right, but they also do many of the same things wrong. So, if you’re capable of looking at a problem and solving it in a way that no one else has thought of, there might be room for you. Many new people break into the industry and prosper, every single year.

But if that’s going to happen to you, it will take being as near to error free as you’ve ever imagined being, in a dozen different ways, and a little good luck besides. For people from the peasant classes like you and me, there will be very little room for even tiny mistakes, let alone more obvious ones like hookers, dwarf tossing, and huge piles of cocaine.

Don’t think of this as a ‘how to’ book. This is more of a ‘how not to’ book. Having watched countless new analysts enter the market over the years, I can tell you that smart people like you tend to make the same set of mistakes in the same sort of ways, when learning to apply scientific reason to market analysis. More often than not, they tend to make them in the same order. One set of logical conclusions tends to lead to another, and then another and another and so on. From where I sit, that standard list of novice errors looks like a very well-worn path.

You may have an idea for a computer trading program that seems totally new to you, but I assure you, the odds that it’s totally new to everyone else are exceptionally small. And to be really successful in the hedge fund world it’s going to have to be. If it really is a golden goose idea that’s profitable in all market conditions just like the ones everyone else is trying to find, then it’s even less likely to be totally original. For 25 years, thousands of the smartest people in the world have been poring over this stuff, 10 hours a day, every day, using all the resources available to a 225 billion dollar a year industry and with the motive of vast riches for the person who finds it. What do you think the odds are that every single one of them missed your particular secret?

But that shouldn’t discourage you. The truth is, people come up with new, consistently profitable ideas every single day. And they’re able to do so because those geniuses I mentioned, all went to the same schools, and learned the same things, in the same way, from the same (mostly mediocre) people. There are assumptions in their view of the world that aren’t necessarily correct, but they treat them as if they were. Identify one of them and build a system around it, and you could be in for an unimagined windfall. That’s the game you’re playing, and the people you’re playing against.

So, this book is designed to try to save you some time. I’m going to tell you how to think about the markets in the way that some of the most successful people in the Institutional world do, in order to help you avoid wasting time on what are obviously fruitless paths. If you’re going to be successful in this business, one thing you’ll certainly come to despise, is wasted time. God knows the rest of us do.

Learning to think about the market the way the top institutions do will give you something else too. It will give you a few of the tools you’ll need in order to present your best ideas to the people you’ll need to, if you hope to manage billions of dollars. I’ll tell you what to focus on and how to talk about it if you want them to believe you. Your idea may be original and ground breaking, but if you can’t describe it in a manner that investors will understand, then all of its originality is wasted. Developing an understanding of how they think about these concerns should help you frame your own ideas into something that the industry will find more appealing and more credible. In institutional finance, highly credible is equal to highly successful.

And though it may not seem this way to you yet, to get to the top, it’s the credibility that has to come first.?