merger arbitrage

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pages: 369 words: 128,349

Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing by Vijay Singal

3Com Palm IPO, Andrei Shleifer, asset allocation, buy and hold, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, fixed income, index arbitrage, index fund, information asymmetry, liberal capitalism, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, Myron Scholes, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, survivorship bias, Tax Reform Act of 1986, transaction costs, Vanguard fund

. • Not all announced deals are candidates for merger arbitrage. If only the recommended deals are accepted, the annualized raw return increases to more than 16 percent. Execution of one stock deal is illustrated. Bottom Line Merger arbitrage can generate continuous and sustainable abnormal returns of 4–10 percent annually. Evidence relating to the profitability of merger arbitrage is long-term and consistent. Mutual funds specializing in merger arbitrage are a convenient way to earn a reasonable yet low-risk return. Stocks can be used to execute merger arbitrage transactions on an individual basis to possibly generate higher returns.

The profitability of merger arbitrage can be improved by carefully selecting mergers in which large arbitrageurs are unlikely to participate but which generate higher abnormal returns. Description Though merger arbitrage or risk arbitrage is used extensively by institutions and sophisticated investors, it is not frequently discussed in the media.1 The first major public disclosure of merger arbitrage was made by Ivan Boesky in his 1985 book Merger Mania—Arbitrage: Wall Street’s Best Kept Money-Making Secret, though a couple of stories had run in the popular press.2 The purpose of merger arbitrage is to take advantage of a mispricing that might occur after the intended merger has been announced.

Further, the chance that the target will remain independent is only 14–15 percent. Overall, the evidence presented in Tables 9.1 to 9.3 suggests that there is indisputable proof of positive abnormal returns from merger arbitrage. The excess returns to merger arbitrage vary between 4 percent and 33.9 percent. Factors in Determination of Profits To optimize the gains from merger arbitrage, it is necessary to predict which offers are likely to provide maximum gains. There are Merger Arbitrage three main factors that affect the magnitude of arbitrage profits: probability of success, time from announcement to completion or withdrawal, and arbitrage activity.


pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Bear Stearns, Black-Scholes formula, Brownian motion, business cycle, buy and hold, buy low sell high, buy the rumour, sell the news, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk free rate, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, systematic trading, tail risk, technology bubble, time value of money, total factor productivity, transaction costs, two and twenty, value at risk, Vanguard fund, yield curve, zero-coupon bond

If the maximum position size is set more conservatively to 3%, then the merger arbitrage manager needs to invest in a wide variety of merger deals, covering a large fraction of all deals that take place, and this is in fact a typical behavior among merger arbitrage managers. As we will see in the historical return numbers below, the return to a diversified portfolio of merger arbitrage deals has been very good. That is, merger arbitrage managers have done well simply earning the deal-risk liquidity premium, even without special information regarding particular deals. Consistently, Warren Buffett (1988 annual report) says of merger arbitrage that “the trick, à la Peter Sellers in the movie, has simply been Being There.”

The deal spread reaches an efficiently inefficient level where merger arbitrage managers are compensated for their liquidity provision. At times when the total number and risk of merger deals is large relative to the merger arbitrage capital, the expected return increases. The deal spread also tends to be efficiently inefficient when compared across different merger deals. Indeed, since merger arbitrage managers try to figure out which deals are more likely to fail and which are likely to go through, buying the target shares only in the deals they think will succeed, riskier deals tend to have wider deal spreads. The Life of a Merger Arbitrage Trade The life of a merger arbitrage trade starts when a merger is announced.

This effect is associated with short-lived increases in both media coverage and bidder valuation.” Furthermore, they find that floating-exchange rate bidders disseminate more news around the pricing period, perhaps trying to talk up their stock price when it matters the most. Merger Arbitrage Portfolio Portfolio construction is an important part of merger arbitrage. The merger arbitrage manager must decide which merger targets to buy and how to size the positions. To do this, the merger arbitrage manager must first consider the available universe of mergers at any given time. There are a lot of mergers and acquisitions going on almost all the time. Mitchell and Pulvino (2001) identify 9,026 U.S. merger transactions from 1963 to 1998, corresponding to 251 transactions per year on average.


Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

Asian financial crisis, asset allocation, backtesting, buy and hold, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Pareto efficiency, Performance of Mutual Funds in the Period, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, stochastic process, survivorship bias, systematic trading, tail risk, technology bubble, transaction costs, value at risk, zero-sum game

To prove that managed futures are an excellent diversifying agent for other hedge fund strategies, we construct a portfolio that is 50 percent managed futures and 50 percent merger arbitrage. Table 9.3 presents the Monte Carlo VaR for merger arbitrage alone and for the combined portfolio of merger arbitrage/managed futures. We note first that the VaR for merger arbitrage alone are significantly larger (in absolute value) than that for the combined portfolio. This is consistent with a short put option position— being on the hook for potential losses in a market downturn. 5See Anson and Ho (2003) for an examination of the nature of short volatility strategies. Merger Arbitrage Excess Returns 200 RISK AND MANAGED FUTURES INVESTING 4.00% 2.00% 0.00% –2.00% –4.00% –6.00% –8.00% –20.00% –15.00% –10.00% –5.00% 0.00% 5.00% 10.00% 15.00% S&P 100 Excess Returns Merger Arb Regression Line Coefficient Threshold alow blow ahigh bhigh S.E.

R-Squared FIGURE 9.13 −0.0451 0.0265 0.4769 0.0069 0.0410 0.0112 0.2692 t-statistic 5.67 6.10 1.50 Merger Arbitrage We also can see that the VaR at the 1 percent level and 5 percent for the combined portfolio as well as the maximum loss are approximately onehalf of that for merger arbitrage alone. These results demonstrate the complementary behavior of managed futures with merger arbitrage. The combination of managed futures with merger arbitrage greatly reduces the risk of loss compared to merger arbitrage as a stand-alone investment. Our work supports that of Kat (2002) for blending managed futures with other hedge fund styles to minimize and manage volatility risk. 201 Measuring the Long Volatility Strategies of Managed Futures TABLE 9.3 Monte Carlo Value at Risk 1 Month VaR @ 1% Confidence Level 1 Month VaR @ 5% Confidence Level Maximum Loss Number of Simulations Merger Arbitrage Merger Arbitrage and Managed Futures −6.04000% −3.1500% −3.1400% −10.7400% −1.7340% −5.5210% 10,000 10,000 Finally, in Figure 9.15, we present the distribution of returns associated with our combined portfolio managed futures and merger arbitrage.

Specifically, those hedge fund strategies that use short-volatility strategies will benefit from the diversification benefits of adding long-volatility strategies to a portfolio of hedge fund managers. Two hedge fund styles use shortvolatility strategies: merger arbitrage and event driven. Merger arbitrage managers take a bet that the merger will be completed. They analyze antitrust regulations, consider whether the bid by the acquiring company is hostile or friendly, and check on potential shareholder opposition to the merger. If the merger is completed, the merger arbitrage manager earns the spread that it previously locked in through its long and short stock positions. However, if the merger falls through, the merger arbitrage manager may incur a considerable loss that cannot be known in advance.


pages: 244 words: 79,044

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

activist fund / activist shareholder / activist investor, Bear Stearns, Bernie Madoff, capital asset pricing model, corporate raider, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, intangible asset, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, NetJets, new economy, Ponzi scheme, post-work, risk free rate, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

Since the deal coincided with the very large and complex bank transaction in the UK in which Royal Bank of Scotland bought NatWest, any fund without a European merger arbitrage presence scrambled to get one, and massive amounts of capital flowed to the strategy and region. With the internet bubble popping in 2000/01 and a subsequent slowdown in business combinations, a lot of new merger-arbitrage analysts had to look elsewhere to make money. Good merger-arbitrage analysts are often not good value investors and don’t have a lot of experience at valuing companies in the typical investment-banking fashion. This was where I thought I could provide an angle to make some money for HBK and myself.

Over the past seven days I had lost any hope of becoming a scuba-diver, but gained a job in merger arbitrage and special situations investing. London beckoned … and I was eager to follow my new calling. 2 * * * Taking the plunge Joining ‘The Firm’ HBK was founded in the early 1990s as a convertible arbitrage shop. Harlan Korenvaes had used his connections from heading the convertibles group at Merrill Lynch to raise money for his own venture. Since inception, the returns had been excellent. After the early days of focusing on one area, the firm had quickly expanded into others such as fixed-income arbitrage, merger arbitrage, emerging-markets fixed-income, and special situations.

I remember thinking ‘Cool’ and counting the performance fee we would make on the profits, but felt a bit unexcited about it all. Sam congratulated me on the deal and told me jokingly to keep up my 100 per cent record of successful deals. If only … 1999 and 2000 were very busy years for merger arbitrage in Europe. The transaction where British mobile company Vodafone bought the German Mannesmann in a $200-billion share deal was the peak of European and perhaps world merger arbitrage. This deal had it all: regulatory complexity, currency angle, unclear merger ratio, hostile takeover, massive downside if the deal broke, and virtually unlimited liquidity. Many of the larger US hedge funds had $100-million positions, where they were long Mannesmann and short Vodafone to lock in the spread on the transaction (the difference between the Mannesmann share price and the consideration you would receive in Vodafone shares if the deal went through).


pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

3Com Palm IPO, asset allocation, Bear Stearns, Bernie Madoff, Brownian motion, buy and hold, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, tail risk, transaction costs, two-sided market, value at risk, yield curve

Merger arbitrage funds seek to profit by buying shares in the target company (and hedging with sales of the acquiring company if the merger deal is a stock exchange at a specified ratio rather than cash acquisition). Merger arbitrage funds will profit from the closing of the discount if the deal is completed and will minimize losses to the extent they are able to avoid deals that break. Merger arbitrage funds are highly dependent on the level of merger activity and the level of discounts. When there is a sharp expansion in merger activity, such as occurred in 1999–2000 and 2006, merger arbitrage funds will do well. However, periods of depressed merger activity, such as 2001 to 2005, will be accompanied by low or negative returns. The level of returns of any merger arbitrage fund is more likely to be a reflection of the level of past merger activity than of manager skill, and there is no reason to assume that past merger conditions will have any predictive value for the level of future merger activity.

Since a large majority of announced mergers are completed, most such trades will be profitable. The risk in the strategy is that if the deal breaks, the resulting loss can be many multiples of the discount that would have been earned. To be successful, merger arbitrage managers need to have the expertise and skill to select those mergers that will end up being completed. Some merger arbitrage managers will also occasionally seek to profit by doing a reverse merger arbitrage trade on announced mergers they believe will fail to be successfully concluded. Convertible arbitrage. Convertible bonds are corporate bonds that pay a fixed interest payment but also include a built-in option to exchange the bond into a fixed number of shares before maturity.

We now look at two hedge fund strategies to illustrate the impact of strategy category on performance: Merger arbitrage. When a merger deal is announced, the target company’s stock price will jump to some level below the announced acquisition price. The discount exists because there is some uncertainty whether the deal will be completed. This discount will diminish over time as the likelihood of a successful transaction increases, and will approach zero if the merger is successfully completed. Merger arbitrage funds seek to profit by buying shares in the target company (and hedging with sales of the acquiring company if the merger deal is a stock exchange at a specified ratio rather than cash acquisition).


pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

asset allocation, backtesting, Bear Stearns, Bernie Madoff, Black Swan, business cycle, buy and hold, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, Myron Scholes, passive investing, Richard Feynman, Richard Feynman: Challenger O-ring, risk free rate, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, stocks for the long run, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

These trading managers invest in events such as liquidations, spin-offs, industry consolidations, reorganizations, bankruptcies, mergers and acquisitions, recapitalizations, share buybacks, and other corporate transactions. CASAM/CISDM Merger Arbitrage Index (CISDM Merger Arbitrage): The median performance of merger arbitrage managers reporting to the CASAM/CISDM Hedge Fund Database. Merger arbitrage represents strategies that concentrate on companies that are the subject of a merger, tender offer, or exchange offer. While there are a number of different trading based approaches, merger arbitrage strategies often take a long position in the acquired company and a short position in the acquiring company. CASAM/CISDM Emerging Markets Index (CISDM Emerging Markets): The median performance of emerging market managers reporting to the CASAM/ CISDM Hedge Fund Database.

Exhibit 8.11 emphasizes the relationships between noninvestable CISDM hedge fund indices and the investable Hedge Fund Research (HFRX) 186 EXHIBIT 8.10 THE NEW SCIENCE OF ASSET ALLOCATION Performance of Alternative Hedge Fund Indices (2001–2008) Barclays Hedge Fund Index CISDM Equal Weighted Hedge Fund Index CSFB/Tremont Hedge Fund Index HFRI Fund Weighted Composite Index Barclays Equity Market Neutral CISDM Equity Market Neutral CSFB/Tremont Equity Market Neutral HFRI Equity Market Neutral Barclays Fixed Income Arbitrage CISDM Fixed Income Arbitrage CSFB/Tremont Fixed Income Arbitrage Barclays Hedge Convertible Arbitrage CISDM Convertible Arbitrage CSFB/Tremont Convertible Arbitrage HFRI Convertible Arbitrage Barclays Event Driven CISDM Event Driven Multi-Strategy CSFB/Tremont Event Driven HFRI Event Driven Barclays Merger Arbitrage CISDM Merger Arbitrage CSFB/Tremont Risk Arbitrage HFRI Merger Arbitrage Barclays Distressed Securities CISDM Distressed Securities CSFB/Tremont Distressed HFRI Distressed Securities Barclays Equity Long Short CISDM Equity Long/Short CSFB/Tremont Long/Short Equity HFRI Equity Hedge Barclays Global Macro CISDM Global Macro CSFB/Tremont Global Macro HFRI Macro Barclays Emerging Markets CISDM Emerging Markets CSFB/Tremont Emerging Markets Annualized Return Standard Deviation 5.1% 5.6% 5.4% 5.0% 4.1% 5.6% 0.4% 3.3% 1.3% 3.6% 0.8% 1.7% 3.3% 1.2% 0.7% 6.6% 5.6% 7.6% 6.0% 5.7% 4.8% 4.1% 4.3% 6.6% 7.6% 8.5% 7.7% 4.8% 4.4% 4.5% 2.8% 7.7% 6.4% 11.6% 8.8% 9.7% 7.9% 8.7% 6.6% 6.6% 5.6% 6.4% 3.1% 2.0% 14.7% 2.9% 6.4% 4.8% 7.1% 7.5% 6.2% 7.9% 8.2% 6.3% 6.3% 5.6% 7.1% 3.8% 3.4% 3.9% 3.7% 7.3% 6.0% 6.1% 6.6% 5.4% 6.0% 7.2% 8.2% 5.2% 3.3% 5.5% 5.1% 12.6% 10.5% 10.3% Return and Risk Differences among Similar Asset Class Benchmarks 187 Correlation Information Ratio Maximum Drawdown 0.78 0.84 0.97 0.78 1.34 2.84 0.03 1.16 0.20 0.74 0.11 0.23 0.53 0.15 0.08 1.05 0.90 1.36 0.85 1.50 1.43 1.04 1.16 0.91 1.26 1.40 1.18 0.89 0.73 0.62 0.34 1.47 1.93 2.10 1.71 0.77 0.75 0.84 −23.1% −21.1% −19.7% −20.5% −6.1% −2.8% −42.7% −8.3% −28.6% −19.3% −29.0% −31.5% −22.5% −32.9% −35.3% −19.6% −20.2% −18.9% −23.9% −7.2% −5.7% −8.2% −8.1% −34.3% −21.2% −21.5% −26.9% −14.0% −17.0% −21.6% −28.5% −6.4% −2.6% −14.9% −4.9% −40.1% −35.3% −30.9% S&P 500 BarCap US Aggregate CISDM HF Strategy Index 0.78 0.79 0.62 0.80 −0.13 0.44 0.21 0.02 0.50 0.56 0.44 0.48 0.46 0.45 0.49 0.72 0.76 0.62 0.77 0.62 0.66 0.56 0.66 0.58 0.65 0.58 0.58 0.77 0.77 0.68 0.81 0.30 0.30 0.21 0.13 0.75 0.69 0.69 0.01 0.00 0.05 −0.03 −0.03 0.00 −0.22 −0.07 0.11 0.11 0.19 0.25 0.32 0.21 0.26 −0.08 0.00 −0.04 −0.04 0.06 0.05 0.14 0.06 −0.02 0.10 −0.07 −0.01 −0.11 −0.10 0.04 −0.07 0.12 0.11 0.30 0.12 0.05 0.09 0.10 0.99 1.00 0.91 0.99 0.57 1.00 0.07 0.59 0.85 1.00 0.89 0.97 1.00 0.93 0.97 0.94 1.00 0.92 0.96 0.86 1.00 0.67 0.90 0.87 1.00 0.83 0.91 0.98 1.00 0.91 0.96 0.81 1.00 0.45 0.76 0.98 1.00 0.95 188 CISDM Equal Weighted Hedge Fund Index HFRX Equal Weighted Strategies Index CISDM Equity Market Neutral HFRX Equity Market Neutral CISDM Convertible Arbitrage HFRX Convertible Arbitrage CISDM Distressed Securities HFRX Distressed Securities CISDM Event Driven Multi-Strategy HFRX Event Driven CISDM Merger Arbitrage HFRX Merger Arbitrage CISDM Equity Long/Short HFRX Equity Hedge 7.2% 6.6% 2.2% 3.4% 7.4% 18.2% 6.8% 8.2% 6.9% 7.3% 3.8% 3.8% 6.3% 8.6% −1.7% .3% 1.4% −0.9% −15.7% 4.2% −2.7% 3.3% −0.2% 5.4% 5.1% 4.1% −2.2% Standard Deviation 3.8% Annualized Return 0.48 (0.03) 1.43 1.35 0.65 (0.26) 0.62 (0.33) (0.86) (0.12) 0.42 2.45 (0.25) 0.53 Information Ratio 0.29 −6.0% 0.88 1.00 0.80 1.00 0.96 1.00 0.83 1.00 0.91 −60.4% −21.2% −31.8% −20.2% −25.8% −5.7% −3.4% −17.0% −28.5% 1.00 1.00 −2.8% −22.5% 0.93 1.00 CISDM Strategy Index −23.6% −21.1% Maximum Drawdown Comparison on Noninvestable and Investable Indices (2004−2008) Performance and Correlations 2004–2008 EXHIBIT 8.11 0.87 0.86 0.77 0.55 0.77 0.83 0.82 0.61 0.75 0.69 0.05 0.49 0.80 0.82 S&P 500 0.05 0.04 0.10 0.28 0.03 0.06 0.11 −0.11 0.19 0.37 −0.24 0.06 0.12 0.12 BarCap US Aggregate Correlation 0.76 0.71 0.63 0.47 0.60 0.70 0.81 0.54 0.80 0.80 −0.11 0.37 0.75 0.74 BarCap US Corporate High-Yield Return and Risk Differences among Similar Asset Class Benchmarks 189 indices over the period 2004 to 2008.1 The HFRX indices are based on a set of managers that provide daily transparency and follow a set of selection rules (e.g., size, years since inception) that are typically demanded by large institutional investors.

Currently several noninvestable as well as investable manager based CTA indices are available. 144 0.39 1.00 0.78 0.80 0.73 0.50 0.74 0.53 0.12 0.39 0.45 0.54 0.68 0.61 0.65 0.76 0.57 Fixed Income Arbitrage 1.00 Equity Market Neutral 0.24 0.53 0.69 0.56 0.71 0.79 1.00 0.78 0.45 Convertible Arbitrage 0.36 0.75 0.83 0.68 0.90 1.00 0.79 0.80 0.54 Distressed Securities CISDM Hedge Fund Strategy Correlations (2001–2008) CISDM Equity Market Neutral CISDM Fixed Income Arbitrage CISDM Convertible Arbitrage CISDM Distressed Securities CISDM Event Driven Multi-Strategy CISDM Merger Arbitrage CISDM Emerging Markets CISDM Equity Long/Short CISDM Global Macro EXHIBIT 7.7 0.47 0.89 0.86 0.82 1.00 0.90 0.71 0.73 0.68 Event Driven Multi-Strategy 0.45 0.79 0.65 1.00 0.82 0.68 0.56 0.50 0.61 Merger Arbitrage 0.47 0.83 1.00 0.65 0.86 0.83 0.69 0.74 0.65 Emerging Markets 0.60 1.00 0.83 0.79 0.89 0.75 0.53 0.53 0.76 Equity Long/Short 1.00 0.60 0.47 0.45 0.47 0.36 0.24 0.12 0.57 Global Macro 145 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% – 1.00% – 2.00% – 3.00% – 4.00% – 5.00% – 6.00% EXHIBIT 7.8 Average Monthly Return CISDM Distressed Securities CISDM Emerging Markets CISDM Convertible Arbitrage CISDM Merger Arbitrage CISDM Hedge Fund Strategy Returns Ranked by S&P 500 (2001–2008) CISDM Global Macro CISDM Equity Market Neutral Middle 32 Months S&P 500 Worst 32 Months CISDM Equity Long/Short CISDM Event Driven Multi-Strategy CISDM Fixed Income Arbitrage Best 32 Months 146 THE NEW SCIENCE OF ASSET ALLOCATION Sources of Managed Futures Return The sources of return to managed futures are uniquely different from traditional stocks, bonds, or even hedge funds.


pages: 321

Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

algorithmic trading, asset allocation, automated trading system, backpropagation, backtesting, barriers to entry, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial intermediation, Flash crash, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, Performance of Mutual Funds in the Period, popular capitalism, prediction markets, price discovery process, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve

In every phase of the business and economic cycle, companies are pursuing ways to unlock shareholder value, so there is always some type of corporate event happening. Merger arbitrage events are quite frequent when the economy expands, for example, and distressed-strategy events are more common when the economy contracts. Figure 25.1 lists corporate events that are more frequent in various phases of the business cycle. MERGER ARBITRAGE Merger, or risk, arbitrage is probably the best-known event-driven investment strategy. In a merger, two companies mutually agree to join together, which often involves an exchange of shares.

In an acquisition, there is a clear-cut buyer (the acquirer) and seller (the target). Often, M&A begins as an acquisition, perhaps unfriendly, but eventually the target succumbs and agrees to a merger. Merger arbitrage is a bet that the deal will or will not close. Some of the major reasons companies make acquisitions are listed in Table 25.1. 198 Finding Alphas Since hedge funds began to proliferate in the 1990s, merger arbitrage has been a classic market-neutral strategy. However, the activity goes back to the 1940s, when Gustave Levy created the first arbitrage desk on Wall Street at investment bank Goldman, Sachs & Co.

Goldman has been a valuable training ground for hedge fund managers, including Daniel Och, Richard Perry, and Tom Steyer, who came out of its risk arbitrage group in the 1980s to start their own firms. In fact, merger arbitrage was never more powerful than during the buyout boom of the 1980s, when arbitrageurs provided the leverage in many of that era’s hostile deals. The merger arbitrage process typically begins when the acquirer approaches the target company with the proposal of a merger or acquisition. This discussion happens at the board of directors level and is kept confidential. If the companies agree on a deal, a press release discloses the important terms of the merger, such as the offer price for the target company (or the exchange ratio of the shares in the case of a merger) and whether the deal will be paid for in cash or in stock.


Investment: A History by Norton Reamer, Jesse Downing

activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Bear Stearns, Berlin Wall, Bernie Madoff, break the buck, Brownian motion, business cycle, buttonwood tree, buy and hold, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, dogs of the Dow, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, impact investing, index fund, information asymmetry, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, pension reform, Performance of Mutual Funds in the Period, Ponzi scheme, Post-Keynesian economics, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Savings and loan crisis, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, survivorship bias, tail risk, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, two and twenty, underbanked, Vanguard fund, working poor, yield curve

Even more than lead an opulent lifestyle, Boesky also tried to cultivate an aura of great financial sophistication. He liked to claim that his success was due to mastery of strategies like merger arbitrage, a concept about which he had heard from a former classmate. Later Boesky even published a book entitled Merger Mania with a subtitle of Arbitrage: Wall Street’s Best Kept Money-Making Secret.131 The strategy itself was relatively simple. In the basic form of merger arbitrage, investors purchase debt or equity in a corporation that might soon be the target of a merger or acquisition. The investors do this in anticipation of a spread between the offer price announced in the deal and the price at which the target’s securities were trading before the announcement.

Market participants with very flexible mandates were able to earn a premium for entering into the area of regulatory capital trades that few others could take on because of mandate fragmentation. To consider an alternative example, merger arbitrage spread—the premium earned by buying a firm that another company intends to acquire and holding it until the deal closes—sometimes grows when the volume of available deals grows. This is not because the deals have become more risky but, rather, because there is a limited amount of capital that buys in to merger arbitrage deals. In theory, the price of risk should be a function of just a few variables according to the capital asset pricing model, namely, the risk-free rate, the equity premium, the beta of the asset, and factor premiums like size and value.

In the strategy’s more complex form, investors buy and sell securities and derivatives related to a merger or acquisition after the deal has been announced, carefully evaluating the relative value of the various instruments and, above all, the risk that the transaction will not be consummated (due to failure to gain shareholder approval, regulatory sign-off, or sufficient financing for the deal or to another obstruction to the process).132 Although this strategy is well known and well understood today, it was much more esoteric in the 1960s when Boesky first pursued it. The real secret to his wealth, though, was not brilliant utilization of a merger arbitrage strategy; it was instead a strategy as old as time—to play “hardball” to stay ahead.133 Boesky consistently relied on insider information and failed to disclose who else was working with him to influence the market. Figures like Dennis Levine, Michael Milken, and Martin Siegel, whose firms had access to information—for example, by virtue of being retained in an advisory capacity on merger and acquisition deals—clandestinely and illegally worked with Boesky to pass along information on what to purchase so that they could share in the profits.134 Illustrating how Boesky’s schemes worked, an early deal Martin Siegel fed Boesky involved Diamond Shamrock, a chemical company that was at the time interested in expanding its operations in oil and planning to do so through an acquisition.


pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

Andrei Shleifer, asset allocation, Bear Stearns, Bernie Madoff, business process, carried interest, corporate raider, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, John Meriwether, Long Term Capital Management, mail merge, margin call, mass immigration, merger arbitrage, money market fund, Myron Scholes, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, tail risk, Thales and the olive presses, Thales of Miletus, the new new thing, too big to fail, transaction costs, two and twenty, Vanguard fund, Y2K, Yogi Berra, zero-sum game

Event Driven—One Man’s Loss Is Another Man’s Gain As the name implies, event-driven strategies attempt to capitalize on opportunities that occur within a company and exploit pricing anomalies that result from a specific event. Oftentimes, these strategies occur before or after a merger or acquisition (hence the name merger arbitrage), bankruptcy, buyout, or spin-off. In this instance, a hedge fund manager takes a significant position in a limited number of companies with special situations—and by special I mean unusual situations that provide money-making opportunities. Event-driven strategies can be further subdivided into the following: Merger Arbitrage Distressed Securities In 1985, Tom Steyer—a former Goldman Sachs compatriot who escaped the hustle and bustle of Wall Street in favor of San Francisco—started Farallon and created the event-driven fund.

Two simple examples of taking advantage of micro inefficiencies would occur in the following strategies: 1. Long/Short Equity: The manager believes a certain stock is too cheap in comparison to a competitor or the broader market. In order to profit from this mispricing, the manager would go long the stock and short the market or the competitor. 2. Merger Arbitrage Strategy: If a company is acquiring a smaller competitor in an all-share deal, the manager would short the acquiring company’s stock and go long the company to be acquired to capture the spread between completed acquisition prices and current prices. Oftentimes, however, hedge funds take advantage of larger macro inefficiencies.

The government, antitrust regulators, a shareholder revolution, a possible new buyer, a relentless company—all the players that make up the nightmares of our typical event-driven manager. You get the picture. These are factors that most hedge fund managers cannot control. Although event-driven strategies use very little leverage and historically provided alpha, their moment in the spotlight has surely faded. Why? Event-driven strategies—specifically merger arbitrage—tend to have a higher correlation to the overall market than other hedge fund strategies. Think about it—this is strategy that earns its bread and butter based on mergers and acquisitions, which tend to happen more successfully in a thriving economy. It’s no wonder that this strategy has been underperforming since the 2007 to 2009 economic crisis.


pages: 172 words: 49,890

The Dhandho Investor: The Low-Risk Value Method to High Returns by Mohnish Pabrai

asset allocation, backtesting, beat the dealer, Black-Scholes formula, business intelligence, call centre, cuban missile crisis, discounted cash flows, Edward Thorp, Exxon Valdez, fixed income, hiring and firing, index fund, inventory management, Mahatma Gandhi, merger arbitrage, passive investing, price mechanism, Silicon Valley, time value of money, transaction costs, two and twenty, zero-sum game

Chapter 6 - Dhandho 101: Invest in Existing Businesses Chapter 7 - Dhandho 102: Invest in Simple Businesses Chapter 8 - Dhandho 201: Invest in Distressed Businesses in Distressed Industries Chapter 9 - Dhandho 202: Invest in Businesses with Durable Moats Chapter 10 - Dhandho 301: Few Bets, Big Bets, Infrequent Bets THE AMERICAN EXPRESS SALAD OIL CRISIS Chapter 11 - Dhandho 302: Fixate on Arbitrage 1. TRADITIONAL COMMODITY ARBITRAGE 2. CORRELATED STOCK ARBITRAGE 3. MERGER ARBITRAGE 4. DHANDHO ARBITRAGE Chapter 12 - Dhandho 401: Margin of Safety—Always! Chapter 13 - Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses STEWART ENTERPRISES LEVEL 3 CONVERTIBLE BONDS FRONTLINE Chapter 14 - Dhandho 403: Invest in the Copycats rather than the Innovators CASE STUDY: MCDONALD’S CASE STUDY: MICROSOFT CASE STUDY: PABRAI INVESTMENT FUNDS Chapter 15 - Abhimanyu’s Dilemma—The Art of Selling TO ENTER OR NOT TO ENTER—THAT IS THE QUESTION TRAVERSING THE RINGS UNIVERSAL STAINLESS & ALLOY PRODUCTS EXITING THE CHAKRAVYUH HOW MANY SIMULTANEOUS CHAKRAVYUH BATTLES?

Sometimes holding company stocks trade at a discount to a sum of the parts even if the parts are individually publicly traded. Sometimes the same stock on different exchanges can have price differences. Closed-end funds from time to time trade at significant discounts to their underlying assets. All are candidates for arbitrage plays. 3. MERGER ARBITRAGE Public company A announces it is to buy public company B for $15 a share. Prior to the announcement, B was trading at $10 a share; immediately after the announcement, B goes to $14 a share. If an investor buys B at $14 and holds the stock until the deal closes, then the $1 spread can be captured for a tidy profit in a few months.

Swensen, Unconventional Success: A Fundamental Approach to Personal Investment (New York: Free Press, 2005). 4 See note 3. 5 Joel Greenblatt, The Little Book That Beats the Market (New York: John Wiley & Sons, 2005). Chapter 17 1 Kahlil Gibran, The Prophet (New York: Alfred A. Knopf, 1923). 2 See note 1, pp. 19-22. INDEX A Allstate Insurance Company American Express Company Arbitrage, investing and correlated stock arbitrage Dhandho arbitrage merger arbitrage traditional commodity arbitrage B Barron’s Beat the Dealer (Thorp) Bed Bath and Beyond, Inc. Berkshire Hathaway, see also Buffett, Warren GEICO and Level 3 Communications and management of stock classes of Bets, see Few bets/big bets/infrequent bets Bhide, Amar Blackjack odds Blue Chip Stamps Blumkin, Rose Branson, Richard Buffalo News Buffett Partnerships: American Express and Pabrai Investment Funds and Buffett, Warren, see also Berkshire Hathaway; Buffett Partnerships on arbitrage book recommendation of on buying Washington Post on concentrated equity ownership on distressed businesses on durable moats on efficient markets theory on greed and investing indexes and on moats primary investing rules of on public disclosure of private investments on simple businesses Business publications/financial information sources BusinessWeek C Capital investment, Marwari formula for Chaudhari, Manilal Cherokee International Chipotle Commodity arbitrage Competitive advantage, see Durable moats CompuLink Copycat businesses, investing in McDonald’s Microsoft Pabrai Investment Funds Correlated stock arbitrage Crisis events, DJIA declines after Crowe, Jim D Dhandho investing principles.


pages: 200 words: 54,897

Flash Boys: Not So Fast: An Insider's Perspective on High-Frequency Trading by Peter Kovac

bank run, barriers to entry, bash_history, Bernie Madoff, compensation consultant, computerized markets, computerized trading, Flash crash, housing crisis, index fund, locking in a profit, London Whale, market microstructure, merger arbitrage, prediction markets, price discovery process, Sergey Aleynikov, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, zero day

In fact, there is an entire slice of the hedge fund world called “merger arbitrage” that places bets on whether or not such mergers or acquisitions happen. If the hedge fund thinks that the acquisition will definitely happen, it will buy any shares available if they are below the acquisition price. Conversely, if it thinks that the acquisition will not happen, it is willing to sell shares – and even sell them for less than the acquisition price, since the share price often collapses catastrophically when an acquisition attempt fails. The fact that merger arbitrage is a large and profitable business indicates that the prices of merger targets are far from stable.

The fact that merger arbitrage is a large and profitable business indicates that the prices of merger targets are far from stable. That is why the stock of an acquisition target trades in a narrow range, but is incredibly fragile: if there is a big sale, some merger arbitrage hedge fund immediately worries that another hedge fund has learned that the acquisition has fallen apart, and the stock is about to collapse. Imagine that you have a $50 gift card to Wild Oats, a grocery store about to be acquired by Whole Foods. The local store says that Whole Foods will probably honor the gift card after the acquisition. If I offered to sell you my Wild Oats gift card for $49 – I know I’m losing money but I don’t feel like standing in line and exchanging the card next month – you’d probably buy it.

Briefly, the SEC-CFTC report listed a cascade of events, starting with a highly volatile market that was already in the midst of the biggest one-day drop of that year. The downdraft was then exacerbated by an unusually aggressive series of orders to sell $4.1 billion of a benchmark futures contract. Just as Katsuyama dumping a million shares of Solectron in a jittery merger-arbitrage market caused a “minicollapse,” so did this trade. Only this trade wasn’t in a tiny tech stock, it was a market-wide product. And just as Thor smacked unlucky market-makers, dumping a lot more risk onto them than they anticipated, so did this trade. Naturally, the unlucky market-makers who had just bought billions of dollars of stock futures (in the midst of the market’s worst day all year) looked to hedge their risk.


pages: 302 words: 86,614

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

activist fund / activist shareholder / activist investor, Asian financial crisis, asset allocation, asset-backed security, backtesting, Bear Stearns, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, impact investing, interest rate derivative, Isaac Newton, Long Term Capital Management, Marc Andreessen, Mark Zuckerberg, merger arbitrage, Myron Scholes, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Savings and loan crisis, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading, tail risk, two and twenty, zero-sum game

The portfolio is divided across the $6.5 billion Paulson Merger Funds, the $9.7 billion Credit Opportunities, the $3.0 billion Recovery funds, and the $1.1 billion Gold funds, and the $17.9 billion Advantage funds. Paulson & Co. specializes in three types of event arbitrage: mergers, bankruptcies, and any type of corporate restructuring, spin-off, or recap litigation that affects the value of a security. In merger arbitrage, a major focus of the firm’s proprietary research is to anticipate which deals may receive another bid, and then to weight the portfolio toward those specific deals. The goal of the Paulson funds, like any fund, is to produce above average returns with less volatility and low correlation to the broader equity markets.

It’s Not All Numbers When his firm started to hit its stride in the early 2000s, Paulson drew on some of the skills he’d learned in the nonfinance courses he had taken at Harvard: simple concepts like product/market segmentation. In fact, Paulson credits his marketing knowledge for some of his recent success. He says: “You know, one of the ways we grew was not by coming up with more products but by reformulating the same product.” Paulson Partners originally started out with a domestic merger arbitrage fund in 1994. “While we were not pioneers in the hedge fund space, we still were early in its evolution. By 1996, we thought it may be the right time to launch an international product.” It was the same product, just targeted to different investors. Paulson says: “It was the same portfolio; Paulson International just targeted a foreign investor base and added all the bells and whistles to appeal to international clients.”

These marketing terms helped me create new products for new markets and differentiate the product without more work.” Today, the Enhanced and International funds combined are 11 times the size of the original Paulson Partners Fund. Paulson & Co. launched the Advantage fund in 2003 and the Advantage Plus in 2004. These funds added to the merger arbitrage base by including bankruptcy, distressed, and other forms of event investing. Initially, Paulson & Co. grew slowly, but once it had a five-year track record and proved steady performance, making money in both 2001 and 2002, when many other funds were feeling the strain of the post-9/11 market collapse, it started grabbing investors’ attention.


pages: 192 words: 75,440

Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel

backtesting, barriers to entry, Bear Stearns, collateralized debt obligation, commodity trading advisor, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, family office, fixed income, high net worth, interest rate derivative, interest rate swap, Long Term Capital Management, merger arbitrage, offshore financial centre, random walk, Renaissance Technologies, risk-adjusted returns, rolodex, short selling, side project, statistical arbitrage, stocks for the long run, systematic trading, two and twenty, unpaid internship, value at risk, yield curve, yield management

-based, over-the-counter (OTC), and particularly complex. Note: Fixed income arbitrage is a generic description of a variety of strategies involving investments in fixed income instruments, and weighted in an attempt to eliminate or reduce exposure to changes in the yield curve. Risk Arbitrage Sometimes called merger arbitrage, this involves investment in event-driven situations such as leveraged buyouts (LBOs), mergers, and hostile takeovers. Normally, the stock c01.indd 6 1/10/08 11:00:55 AM Getting Started 7 of an acquisition target appreciates while the acquiring company’s stock decreases in value. Risk arbitrageurs invest simultaneously in long and short positions in both companies involved in a merger or acquisition.

Risk arbitrageurs invest simultaneously in long and short positions in both companies involved in a merger or acquisition. As such, they are typically long the stock of the company being acquired and short the stock of the acquirer. The principal risk is deal risk, should the deal fail to close. Merger arbitrage may hedge against market risk by purchasing Standard & Poor’s (S&P) 500 put options or put option spreads. Statistical Arbitrage Stat arb funds focus on the statistical mispricing of one or more assets based on the expected value of those assets. This is a very quantitative and systematic trading strategy that uses advanced software programs.

My interviewers knew full well that I didn’t have the relevant experience, so the questions were more an assessment of my personality traits. They wanted to know such things as whether I could think out of the box and could work well with the team that was in place. I was also asked some basic finance questions and about what I wanted to get out of the job, such as: Do you understand how options work? Do you know what merger arbitrage entails? What do you know about hedge funds? What is attractive about working at a hedge fund? For the c08.indd 106 1/10/08 11:09:08 AM Operations 107 last, I knew not to say the chance to make a lot of money. Instead, I acknowledged how rare an opportunity it is to come straight out of college and work at a buy-side shop and how I would make the most of it.


pages: 289 words: 113,211

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

"Robert Solow", affirmative action, Albert Einstein, asset allocation, backtesting, beat the dealer, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commoditize, commodity trading advisor, computer age, computerized trading, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, Edward Thorp, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, intangible asset, Jeff Bezos, John Meriwether, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shock, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, selection bias, shareholder value, short selling, Silicon Valley, statistical arbitrage, tail risk, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, William Langewiesche, yield curve, zero-coupon bond, zero-sum game

Virtually all mishaps over the past decades had their roots in the complex structure of the financial markets themselves. Just look at the environment that has precipitated these major meltdowns. For the crash of 1987, it was hard to see anything out of the ordinary. There were a few negative statements coming out of Washington and some difficulties with merger arbitrage transactions—traders who play the market by guessing about future corporate takeovers. What else is new? The trigger for the LTCM crisis was something as remote as a Russian default, a default we all saw coming at that. Compare these with the market 2 ccc_demon_001-006_ch01.qxd 2/13/07 1:44 PM Page 3 I N T R O D U C T I O N : T H E PA R A D O X OF MARKET RISK reaction to events that shook the nation.

The most common approach to classifying hedge funds, one used by Hedge Fund Review, CSFB/Tremont, and Standard & Poor’s, is to organize them based on trading styles. For example, the Standard & Poor’s Hedge Fund Index has three styles: arbitrage, event-driven, and directional/tactical. Each of these styles has three strategic subsets. Arbitrage consists of equity market neutral, fixed income arbitrage, and convertible arbitrage; event-driven has merger arbitrage, distressed, and special situations; directional/tactical has long/short equity, managed futures, and macro. The problem with this sort of classification, based as it is strictly on the trading style or strategy type, is that it has to be revised over time as new strategies emerge and existing ones fail.

Another category for direction that is useful is event, which depicts strategies that usually have low correlation with the market, but on occasion the correlation can be very high (e.g., during a liquidity or credit crisis). 3. Investment type. This provides more information about the specifics of the investment process or strategy. For example, in the neutral classification there is relative value and statistical arbitrage; the event classification would include merger arbitrage, credit arbitrage, and distressed debt. Investment type is the one component of the analysis that will vary over time with the introduction of new investment strategies. 4. Geographic region. Where is the fund trading? Differentiation may be limited to G-10 and emerging markets, or the region can be broken out in more detail. 5.


pages: 198 words: 53,264

Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

activist fund / activist shareholder / activist investor, Airbnb, Albert Einstein, asset allocation, Bear Stearns, bitcoin, Bretton Woods, buy and hold, buy low sell high, cognitive bias, cognitive dissonance, Credit Default Swap, cryptocurrency, Daniel Kahneman / Amos Tversky, endowment effect, financial innovation, fixed income, hindsight bias, index fund, invention of the wheel, Isaac Newton, John Meriwether, Kickstarter, Long Term Capital Management, loss aversion, mega-rich, merger arbitrage, Myron Scholes, Paul Samuelson, quantitative easing, Renaissance Technologies, Richard Thaler, Robert Shiller, Robert Shiller, Snapchat, Stephen Hawking, Steve Jobs, Steve Wozniak, stocks for the long run, transcontinental railway, two and twenty, value at risk, Vanguard fund, Y Combinator

Investors can learn a great lesson from John Paulson, who struck lightning like nobody else before or since. John Paulson started his hedge fund, Paulson & Co., with $2 million of his own money in 1994. He previously spent time at the investment bank Bear Stearns, where he specialized in merger arbitrage. This strategy involves simultaneously buying and selling short the stocks of two merging companies. The trade is executed based on the likelihood that the deal will close. But merger arbitrage is a relatively boring slice of the hedge fund world, and this strategy is not what put John Paulson on the map. Rather it was his massive wager, a full‐on assault against the United States housing bubble.

(Twain investment), 28 No Bull (Steinhardt), 58, 60 Nocera, Joe, 90 Not safe for work (NSFW), Snapchat categorization, 151 Nudge (Thaler), 126 One‐decision stocks, 50 Options, usage, 131 Oreos, comparison, 91 Oregon Transcontinental Railroad, Twain share purchase, 29 O'Reilly Automotive, Sequoia holding, 111 Overconfidence, impact, 61, 75–76, 82 Overtrading, 159 Paige Compositor Manufacturing Company, 31 Paige, James, 30 Paine Webber, Livermore exit, 16 Palmolive, comparison, 91 Paulson & Co., founding, 132 Paulson, John, 3, 129, 131–132 merger/arbitrage, 133 Pearson, Mike, 113 Buffett, contrast, 114 Pellegrini, Paolo, 132–133 Penn Dixie Cement, shares (purchase), 58 Pershing Square Capital Management, 89 Pittsburgh National Bank, 101 Plasmon (Twain investment), 28 Polaroid, trading level, 70 Poppe, David, 114 Portfolio turnover, 69 Portugal, Ireland, Italy, Greece, Spain (PIIGS), 158 Post‐go‐go years meltdown, 147 Post III, William, 131 Price, Teddy, 19–20 Princeton University, 47–48 Private/public investing, history, 149 Profit sharing, 68 Prospect Theory (Kahneman/Tversky), 126 Pyramid schemes, 93 Qualcomm, gains, 57 Quantitative easing program, 134–135 Quantum Fund, 100, 103 Ramirez, Alberto/Rosa, 132 Rational thinking, suspension, 27 Recession, odds (calculation), 38 Renaissance Technologies, 135 Return on equity, term (usage), 4 Reverse crash, 100 Risk, arrival, 32 Risk management, 23 Roaring Twenties, bull market cycle, 7 Robertson, Julian, 58 Roche, Cullen, 99 Rockefeller, John, 30 Rogers, Henry (“Hell Hound”), 30–32 Rooney, Frank, 80, 81 Rosenfeld, Eric, 39, 41 Ruane, Bill, 4, 109, 112 Ruane & Cunniff, 112 Ruane, Cunniff & Goldfarb, 110–111 Russell 3000, 135 Russia, Quantum Fund loss, 103–104 Sacca, Chris, 145, 149–150 Salomon Brothers, 39 Buffett investment, 79 Samuelson, Paul (remarks), 51 San Francisco Call, 31 Schloss, Walter, 4 Schmidt, Eric, 150 Scholes, Myron, 39 Nobel Prize in Economics, 40–41 Schroeder, Alice, 80 Schwager, Jack, 159 Sears, Ackman targeting, 90 Sears Holdings, 109 Securities and Exchange Act, 7 Securities and Exchange Commission (SEC) 13D registration, 90 creation, 22 Security Analysis (Graham), 3–5 See's Candy Berkshire Hathaway purchase, 78 purchase, 142 Self‐esteem, satisfaction (impact), 75–76 Sequoia Fund, 107 operation, 110–111 Shiller, Robert, 75–76, 87 Short squeeze, 93 Silvan, Jon, 94 Simmons, Bill, 151 Simons, Jim, 135 Slack, Sacca investment, 149 Smith, Adam, 68, 121 Snapchat, 151 Snap, going public, 151 Snowball, The, (Schroeder), 80 Social activities, engagement, 87–88 Soros Fund Management, losses, 105 Soros, George, 58, 60, 100, 103 interaction, 102 reform, 121 South Sea Company shares, 37 Speculation, 15 avoidance, 28 SPY, 62 Stagecoach Corporate Stock Fund, 52 Stamp revenues, trading, 141–142 Standard Oil, 30 Standard & Poor's 500 (S&P500) ETF, 62 gains, 112, 114 performance, comparison, 119 shorting, 163 Valeant performance, comparison, 113 Steinhardt, Fine, Berkowitz & Company, opening, 58 Steinhardt, Michael, 55, 58 performance record, 59–60 Steinhardt Overseas Fund, 60 Stoker, Bram, 30 Stock market, choices, 114–115 Stocks crashing/reverse crashing, 100 return, 99 stock‐picking ability, 88 Stock trader, training, 18 Strategic Aggressive Investing Fund, 102 Sunk cost, 110 Sun Valley Conference, 57 “Superinvestors of Graham‐and‐Doddsville, The,” 111–112 Taleb, Nassim, 42 Target, Ackman targeting, 90 TDP&L, 50 Tech bubble, inflation, 57 Technivest, 50 Thaler, Richard H., 75, 126 Thinking, Fast and Slow, (Kahneman), 15 Thorndike, Dorain, Paine & Lewis, Inc., 48 Time horizons, 120 Time Warner, AOL merger, 49 Tim Ferriss Show, The, (podcast), 150 Tim Hortons, spinoff, 89 Tract on Monetary Reform, A, (Keynes), 125–126 Trader (Jones), 119 Trustees Equity Fund, decline, 50 Tsai, Jerry, 65, 68 stocks, trading, 69 ten good games, 71 Tsai Management Research, sale, 70 Tversky, Amos, 81 Twain, Mark (Samuel Clemens), 25, 27, 75 bankruptcy filings, 32 money, losses, 27–32 public opinion, hypersensitivity, 31 Twilio, Sacca investment, 149 Twitter, Sacca investment, 149–150 Uber, Sacca investment, 149 Undervalued issues, selection, 10 Union Pacific, shares (sale), 18 United Copper, cornering, 19 United States housing bubble, 132 University Computing, trading level, 70 US bonds international bonds, spreads, 41 value, decline, 61 U.S. housing bubble, impact, 132 U.S.


pages: 342 words: 99,390

The greatest trade ever: the behind-the-scenes story of how John Paulson defied Wall Street and made financial history by Gregory Zuckerman

1960s counterculture, banking crisis, Bear Stearns, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, index fund, Isaac Newton, Long Term Capital Management, margin call, Mark Zuckerberg, Menlo Park, merger arbitrage, mortgage debt, mortgage tax deduction, Ponzi scheme, Renaissance Technologies, rent control, Robert Shiller, Robert Shiller, rolodex, short selling, Silicon Valley, statistical arbitrage, Steve Ballmer, Steve Wozniak, technology bubble, zero-sum game

To Paulson, there seemed to be a limit to how much money he could make at a large firm like Bear Stearns, especially since most of its profit came from charging customers fees rather than undertaking deals like Anderson with a huge upside. Yet those were the ones he pined for. Few were surprised in 1988 when Paulson told Bear Stearns executives he was leaving to join Gruss. They long ago figured that Paulson at some point would want to launch a career making investments of his own. Gruss & Co. specialized in merger-arbitrage, taking a position on whether or not a merger would take place and investing in shares of companies being acquired. The firm hadn’'t undertaken buyouts on its own, but the Anderson experience convinced the firm’'s founder, Marty Gruss, to test the waters more deeply. He asked Paulson to lead a new effort to do similar buyout deals, hoping to potentially rival firms like KKR.

He asked Paulson to lead a new effort to do similar buyout deals, hoping to potentially rival firms like KKR. Gruss was so eager to hire Paulson that he agreed to make Paulson a general partner and give the young banker a cut of profits racked up by other groups at the firm. Watching Gruss and his father, Joseph, up close, Paulson quickly picked up the merger-arbitrage business. By buying shares of companies being acquired, and selling short companies making acquisitions, Gruss was able to generate profits that largely were shielded from stock-market fluctuations. The ideal Gruss investment had limited risk but held the promise of a potential fortune. Marty Gruss drilled a maxim into Paulson: “"Watch the downside; the upside will take care of itself.”"

But by 1994, the life of leisure was getting a bit tiresome to Paulson. He still dreamed of earning great wealth. It was time, he realized, to go back to work. “"Time was getting on; I realized I needed to focus,”" Paulson says. The surest path to genuine wealth seemed to be investing for himself. So he started a hedge fund, Paulson & Co., to focus on merger-arbitrage, the specialty he had picked up from Gruss. Paulson reached out to everyone he knew, mailing more than five hundred announcements about his firm’'s launch. But he didn’'t get a single response, even after waiving his initial $1 million minimum investment. Paulson never had managed money on his own, didn’'t have much of a track record as an investor, and wasn’'t known to most potential clients.


Systematic Trading: A Unique New Method for Designing Trading and Investing Systems by Robert Carver

asset allocation, automated trading system, backtesting, barriers to entry, Black Swan, buy and hold, cognitive bias, commodity trading advisor, Credit Default Swap, diversification, diversified portfolio, easy for humans, difficult for computers, Edward Thorp, Elliott wave, fixed income, implied volatility, index fund, interest rate swap, Long Term Capital Management, margin call, merger arbitrage, Nick Leeson, paper trading, performance metric, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, survivorship bias, systematic trading, technology bubble, transaction costs, Y Combinator, yield curve

Too subjective Many methods of trading cannot be systematised because it’s impossible to write down a set of relatively simple, objective and generic rules. For more esoteric forms of technical analysis turning a strangely named candlestick pattern into a precise rule is difficult. Another example would be merger arbitrage where you have to assess the likelihood of a deal going through based on analysis of a number of hard to quantify factors. Data limitations Even if a strategy is objective the necessary data might be unavailable. Even if you could write trading rules for merger arbitrage the necessary information about legal and regulatory issues cannot easily be converted into an algorithm friendly format. There might also be a shortage of data.

Mean reversion Any trading strategy where you assume asset prices will revert to an equilibrium or fair value. For example, you might think 1.70 is a fair value for the price of the GPB/USD FX rate. If the rate goes below 1.70 you’ll buy pounds and sell dollars, and if it goes higher you’d sell pounds (and buy dollars). See also relative value. Merger arbitrage A trading strategy, where if a merger or takeover is occurring you buy the company to be acquired, and usually short sell the acquirer as a hedge. Normally this is done at a discount to the takeover price, the gap reflecting uncertainty about whether a deal will go ahead. Profits can be made by selecting deals where the gap is too large given the level of uncertainty.

Thank you for that, and for everything. 301 Index 2001: A Space Odyssey, 19f 2008 crash, 170 Active management, 3 AIG, 2 Algorithms, 175, 199 Alpha, 3, 37, 106, 136 Alternative beta, 3-4 Amateur investors, 4, 6, 16, 48, 177, 210 and lack of diversification, 20 and over-betting, 21 and leverage, 35 and minimum sizes, 102 as day traders, 188 Anchored fitting: see Back-testing, expanding out of sample Annual returns, 178-179 Annualised cash volatility target, 137, 139, 149, 151, 159, 161, 171, 230, 250 Asset allocating investors, 3, 7, 42, 69, 98, 116, 147, 188, 225-244, 259 and Sharpe ratios, 46 and modular frameworks, 96 and the ‘no-rule’ rule, 116, 167, 196, 225, 228 and forecasts, 122-123, 159 and instrument weights, 166, 175, 189, 198-199 and correlation, 170 and instrument diversification multiplier, 175 and rules of thumb, 186 and trading speeds, 190-191, 205 and diversification, 206 Asset classes, 246&f Automation, 18-19 Back-testing, 5, 13-15, 16, 18, 19&f, 28, 53, 64, 67, 87, 113, 122, 146, 170, 182f, 187, 197, 205 and overfitting, 20, 29, 53f, 54, 68, 129f, 136, 145, 187 and skew, 40 and short holding periods, 43 in sample, 54-56 out of sample, 54-56 expanding out of sample, 56-57, 66, 71f, 84, 89f, 167f, 193-194 rolling window, 57-58, 66, 129f and portfolio weights, 69-73 and handcrafting, 85 and correlations, 129, 167&f, 175 and cost of execution, 179 simple and sophisticated, 186 need for mistrust of, 259 See also: Bootstrapping Barclays Bank, 1-2, 11, 31, 114 Barings, 41 Barriers to entry, 36, 43 Behavioural finance, 12 Beta, 3 Bid-Offer spread, 179 Block value, 153-154, 161, 182-183, 214, 219 Bollinger bands, 109 303 Systematic Trading Bond ETFs, 226 Bootstrapping, 70, 75-77, 80, 85-86, 146, 167, 175, 193-194&f, 199, 230, 248, 250 and forecast weights, 127, 205 see also Appendix C BP, 12, 13 Braga, Leda, 26 Breakouts, 109 Buffett, Warren, 37, 42 Calibration, 52-53 Carry, 67, 119, 123, 126, 127-128, 132, 247 and Skew, 119 Koijen et al paper on, 119f Central banks, 36, 103 Checking account value, recommended frequency, 149 Clarke, Arthur C, 19f ‘Close to Open’, 120-121 Cognitive bias, 12, 16, 17, 19-20, 28, 64, 179 and skew, 35 Collective funds, 4, 106, 116, 225 and derivatives, 107 and costs, 181 Commitment mechanisms, 17, 18 Compounding of returns, 143&f Contango: see Carry Contracts for Difference, 106, 181 Contrarians, 45 Corn trading, 247f Correlation, 42, 59f, 63, 68, 70, 73, 104, 107, 122, 129, 131, 167-168, 171 and Sharpe ratios, 64 and trading subsystems, 170 and ETFs, 231 Cost of execution, 179-181, 183, 188, 199, 203 Cost of trading, 42, 68, 104, 107, 174, 178, 181, 230 Credit Default Swap derivatives, 105 Crowded trades, 45 Crude oil futures, 246f Curve fitting: see over-fitting Daily cash volatility target, 137, 151, 158, 159, 161, 162, 163, 172, 175, 217, 218, 233, 254, 262. 270, 271, 217 Data availability, 102, 107 Data mining, 19f, 26-28 Data sources, 43-44 Day trading, 188 Dead cat bounces, 114 Death spiral, 35 DeMiguel, Victor, 743f Derivatives, 35 versus cash assets, 106 Desired trade, 175 Diary of trading, for semi-automatic trader, 219-224 Diary of trading, for asset allocating investor, 234- 244 Diary of trading, for staunch systems trader, 255- 257 Diversification, 20, 42, 44, 73f, 104, 107, 165, 170, 206 and Sharpe ratios, 65f, 147, 165 of instruments rather than rules, 68 and forecasts, 113 Dow Jones stock index, 23 Education of a Speculator, 17 Einstein, 70 Elliot waves, 109 Emotions, 2-3 Equal portfolio weights, 72-73 Equity value strategies, 4, 29, 31 Equity volatility indices, 34, 246, 247 Eurex, 180 Euro Stoxx 50 Index Futures, 179-180, 181, 182, 187-188, 193, 198 Eurodollar, trading recommendation, 247 Exchange rate, 161, 185 Exchange traded funds (ETFs), 4, 106, 183-184, 189, 197, 200, 214, 225, 226-228 holding costs of, 230 daily regearing of, 230f correlations, 231 Exchanges, trading on, 105, 107 Exponentially Weighted Moving Average Crossover 304 Index (EWMAC), 117-123, 126, 127-128, 132, 247 see also Appendix B Human qualities of successful traders, 259-260 Hunt brothers, 17 Fannie Mae and Freddie Mac, 2 Fees, 3 Fibonacci, 37, 109 Forecasts, 110-115, 121-123, 159, 175, 196, 211 scaling of, 112-113, 115, 133 combined, 125-133, 196, 248, 251 weighted average of, 126 and risk, 137 and speed of trading, 178 and turnover, 185 not changing once bet open, 211 see also Appendix D Forecast diversification multiplier, 128-133, 193f, 196, 249, 251 see also Appendix D Foreign exchange carry trading, 36 Fortune’s Formula, 143f FTSE 100 futures, 183, 210 Futures contracts, 181 and block value, 154-155 ‘Ideas First’, 26-27, 52-54, 103, 146 Ilmanen, Antti, 30f Illiquid assets, 198 Index trackers, 106 Inflation, 67 Instrument blocks, 154-155, 175, 182-183, 185, 206 Instrument currency volatility, 182-183, 203, 214 and turnover, 185, 195, 198 Instrument diversification multiplier, 166, 169-170, 171, 173, 175, 201, 206, 215, 229, 232, 253 Instrument forecast, 161, 162 Instrument riskiness, 155, 182 Instrument subsystem position, 175, 233 Instrument weights, 166-167, 169, 173, 175, 189, 198, 201, 202, 203, 206, 215, 229, 253 and Sharpe ratios, 168 and asset allocating investors, 226 and crash of 2008, 244 Gambling, 15, 20 Gaussian normal distribution, 22, 32&f, 39, 111f, 113, 114, 139f German bond futures, 112, 155, 181, 198 Gold, 246f Google, 29 Gross Domestic Product, 1 ‘Handcrafting’, 78-85, 116, 167-168, 175, 194, 199, 230, 248, 259 and over-fitting, 84 and Sharpe ratios, 85-90 and forecast weights, 127, 205 worked example for portfolio weights, 231-232 and allocation for staunch systems traders, 253 Hedge funds, 3, 177 High frequency trading, 6, 16, 30, 36, 180 Holding costs, 181 Housekeeping, daily, 217 for staunch systems traders, 254 Japan, 36 Japanese government bonds, 102, 112, 114, 200 JP Morgan, 156f Kahn, Richard, 42 Kaufman, Perry, 117 Kelly, John, and Kelly Criterion, 143-146, 149, 151 ‘Half-Kelly’ 146-147, 148, 230, 260 Koijen, Ralph, 119 Law of active management, 41-42, 43, 44, 46, 129f and Sharpe ratios, 47 Leeson, Nick, 41 Lehman Brothers, 2, 237 Leverage, 4, 21&f, 35, 95f, 138f, 142-143 and skew, 44-45 and low-risk assets, 103 and derivatives, 106 and volatility targeting, 151 realised leverage, 229 Life expectancy of investor, and risk, 141 305 Systematic Trading Limit orders, 179 Liquidity, 35, 104-105, 107 Lo, Andrew, 60f, 63f Long Term Capital Management (LTCM), 41, 46 Sharpe ratio of, 47 Low volatility instruments, need to avoid, 143, 151, 210, 230, 260 Lowenstein, Roger, 41, 46f Luck, need for, 260 Lynch, Peter, 37 Markowitz, Harry, 70, 72 Maximum number of bets, 215 Mean reversion trading, 31, 43, 45, 52, 213f ‘Meddling’, 17, 18, 19, 21, 136, 260 and forecasts, 115 and volatility targets, 148 Merger arbitrage, 29 Mid-price, 179, 181 Minimum sizes, 102, 107 Modular frameworks, 93, 95-99 Modularity, 5 Momentum, 42, 67, 68, 117 Moving averages, 94, 195, 197 MSCI, 156f Narrative fallacy, 20, 27, 28, 64 NASDAQ futures, 188 Nervousness, need for, 260 New position opening, 218 Niederhoffer, Victor, 17 Odean, Terence, 13, 20f Odysseus, 17 Oil prices, standard deviation of, 211 O’Shea, Colm, 94f Online portfolio calculators, 129f Overbetting, 21 Over the counter (OTC) trading, 105, 106, 107, 183f Overconfidence, 6, 17, 19f, 54, 58, 136 and lack of diversification, 20 and overtrading, 179 306 Over-fitting, 19-20, 27-28, 48, 51-54, 58, 65, 68, 121f, 156, 259 and Sharpe ratios, 46f, 47, 146 avoiding fitting, 67-68 of portfolio weights, 68-69 possibility of in ‘handcrafting’, 84 Overtrading, 179 Panama method, 247&f Passive indexing, 3 Passive management, 3, 4 Paulson, John, 31, 41 Pension funds, 3 ‘Peso problem’, 30&f Position inertia, 173-174, 193f, 196, 198, 217 Position sizing, 94, 153-163, 214 Poundstone, William, 143f Price movements, reasons for, 103, 107 Portfolio instrument position, 173, 175, 218, 254, 256, 257 Portfolio optimization, 70-90, 167 Portfolio size, 44, 178 Portfolio weighted position, 97, 99, 101, 109, 125, 135, 153, 165, 167, 177, 267 and diversification, 170 Price-to-earnings (P/E) ratios 4 Prospect theory, 12-13, 37 and momentum, 117 Quant Quake, the, 46 Raspberry Pi micro computers, 4 Relative value, 30, 43, 44-46, 213f Retail stockbrokers, 4 Risk, 39, 137-148, 170 Risk targeting, 136 Natural risk and leverage, 142 Risk parity investing, 38, 116&f Risk premia, 31, 119 RiskMetrics (TM), 156&f Roll down: see Carry Rolling up profits and losses, 149 Rogue Trader, 41 Rounded target position, 173, 175, 218 Index Rules of thumb, 186, 230 see also Appendix C Rumsfeld, Donald, 39&f Safe haven assets, 34 Schwager, Jack, 94f Self-fulfilling prophecies, 37 Semi-automatic trading, 4, 7, 11f, 18, 19f, 37, 38, 98, 163, 169, 209-224, 259 and portfolio size, 44, 203 and Sharpe ratios, 47, 147-148 and modular frameworks, 95 and trading rules, 109 and forecasts, 114, 122-123, 159 and eyeballing charts, 155, 195, 197, 214 and diversification, 166, 206 and instrument weights, 166, 175, 189 and correlation, 169 and trading subsystems, 169 and instrument diversification multiplier, 171, 175 and rules of thumb, 186 and overconfidence, 188 and stop losses, 189, 192 and trading speeds, 190-192, 205 Sharpe ratios, 25, 31-32, 34, 35, 42, 43, 44, 46-48, 53, 58, 60f, 67, 72, 73, 112, 184, 189, 210, 214, 250, 259 and overconfidence, 54, 136, 151 and rule testing, 59-60, 65 and T-Test, 61-63 and skew, 62f, 66 and correlation, 64 and diversification, 65f difficulty in distinguishing, 74 and handcrafting, 85-90 and factors of pessimism, 90 and risk, 137f, 138 and volatility targets, 144-145, 151 and speed of trading, 178-179, 196, 204 need for conservative estimation of, 195 and asset allocating investors, 225 and crash of 2008, 240 Schatz futures: see German bond futures Shefrin, Hersh, 13&f Short option strategies, 41 Short selling, 30, 37 Single period optimisation, 71, 85, 89 Skew, positive and negative, 32-34, 40-41, 48, 105, 107, 136, 139-141, 247, 259 and liquidity, 36 and prospect theory, 37 and risk, 39, 138 and leverage, 44-45, 142 and Sharpe ratios, 47, 62f, 146 and trend following, 115, 117 and EWMAC, 119 and carry, 119 and V2TX, 250 ‘Social trading’, 4f Soros, George, and sterling, 36f Speed of trading, 41-43, 47, 48, 104, 122, 174f, 177-205, 248 speed limits, 187-189, 196, 198-199, 204, 213, 228, 251, 260 Spread betting, 6, 106, 181, 197, 214 and block value, 154-155 and UK tax, 183f oil example, 214 Spreadsheets, 218 Stamp duty, 181 Standardised cost estimates, 203-205, 210, 226, 230 Standard deviations, 21-22, 31-32, 38, 40, 70, 103, 107, 111f, 129 and skew, 105 and forecasts, 112, 114, 128 recent, 155-158 returns, 167 and standardised cost, 182, 188, 192 and stop losses, 211 Static and dynamic trading, 38, 43, 168, 188 Staunch systems trading, 4, 7, 51-68, 69, 98, 109, 117-123, 167, 245-257 and Sharpe ratios, 46, 146, 189 and forecasts, 110-114, 122-123, 189 and instrument forecast, 161 and instrument weights, 166, 175, 198-199 and correlation, 170 and rules of thumb, 186 and trading speeds, 191-192, 205 307 Systematic Trading and back-testing, 193 and diversification, 206 Stop losses, 94-5, 115, 121f, 137f, 189, 192, 214, 216f, 217, 218 and forecasts, 211-212 and different instruments, 213 and price volatility, 216 Survivorship bias, 29 Swiss franc, 36, 103, 105, 142-143 System parameters, 186 Systematica hedge fund, 26 Taking profits and losses, 13-15, 16-18, 58, 94-95, 149 and trend following, 37 see also Appendix B Taleb, Nassim, 39f, 41 Tax (UK), 106, 183f Technical analysis, 18, 29 Technology bubble of 1999, 35 Templeton, John, 37 The Black Swan, 39f The Greatest Trade Ever, 31f, 41 Thorpe, Ed, 146f Thriftiness, need for, 260 Timing, 2 Too much/little capital, 206, 246f Trading capital, 150-151, 158, 165, 167, 178, 192, 199-202 starting low, 148 reducing, 149 and turnover, 185 daily calculation of, 217 Trading rules, 3-4, 7, 16, 25-26, 78, 95, 97-98, 101, 109, 121, 125, 135, 159, 161, 187, 249, 259 need for small number of, 67-68, 193 Kaufman, Perry’s guide to, 117 and speed of trading, 178, 205 cost calculations for, 204 see also Appendix B Trading subsystems, 98-99, 116, 159, 162, 163, 165, 166, 167&f, 169, 171f, 172, 175-176, 185, 187, 230, 251-252, 260 and correlation, 170 308 and turnover, 196 cost calculations for, 204 Traditional portfolio allocation, 167 Trend following, 28, 30, 37, 45, 47f, 67, 117, 137f, 194f, 212f, 247 and skew, 105, 115, 117, 213 Turnover, 184-186, 195, 197, 198, 205, 228, 260 methods of calculation, 204 back-testing of, 247-248 Twitter, 29 V2TX index, 246, 247, 249 Value at risk, 137 VIX futures, 105 Volatility, 21, 103, 107, 116, 129, 150, 226, 229 and targets, 95, 98, 106, 158, 159, 185 unpredictability of, 45 price volatility, 155-158, 162-163, 189, 196, 197, 200, 205, 214, 228, Appendix D and crash of 2008, 240-244 instrument currency volatility, 158, 161 instrument value volatility, 161, 172, 250 scalars, 159-160, 162, 185, 201, 206, 215, 217, 218, 229 look-back period, 155, 195-197 and speed of trading, 178 Volatility standardisation, 40, 71, 72, 73, 167, 182, 185 and forecasts, 112, 121, 129 and block value, 155 Volatility standardized costs, 247 Volatility targeting, 135-151, 171f, 188, 192, 201f, 213-215, 230, 233, 250, 259 Walk forward fitting: see Back testing, rolling window Weekly rebalancing process, for asset allocating investors, 233 When Genius Failed, 40, 46f Women as makers of investment decisions, 17&f www.systematictrading.org, 234 Zuckerman, Gregory, 31f THANKS FOR READING!


pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Bear Stearns, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, John Meriwether, Kenneth Rogoff, Kickstarter, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, money market fund, moral hazard, Myron Scholes, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, Paul Samuelson, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Mercer, rolodex, Savings and loan crisis, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, tail risk, technology bubble, The Great Moderation, The Myth of the Rational Market, the new new thing, too big to fail, transaction costs, two and twenty

As a young analyst at Morgan Stanley, he had been upset to discover that investment-bank advisers can be paid for being wrong; sounding convincing mattered more than actually being right, since the objective was simply to extract fees from the clients. After a stint at Stanford’s business school, Steyer had worked at Goldman Sachs for the merger-arbitrage unit run by Robert Rubin, the future Treasury secretary. This suited him better: Goldman got paid in this business only when Goldman was right, though the distribution of the profits among employees sometimes generated arguments. The way Steyer saw things, setting up an independent fund was the logical next step.

Bit by bit, the old talk of luck and genius faded and the new lingo took its place—at hedge-fund conferences from Phoenix to Monaco, a host of consultants and gurus held forth about the scientific product they called alpha. The great thing about alpha was that it could be explained: Strategies such as Tom Steyer’s merger arbitrage or D. E. Shaw’s statistical arbitrage delivered uncorrelated, market-beating profits in a way that could be understood, replicated, and manufactured by professionals. And so the era of the manufacturer arrived. Innovation and inspiration gave way to a new sort of alpha factory. You could see this transformation all over the hedge-fund industry.

Surely this bubble could not last? Wasn’t it bound to end painfully? IN THE MID-2000S, AS THE HEDGE-FUND BUBBLE WAS growing, an outfit named Amaranth emerged as the very model of the modern alpha factory. Its founder, Nick Maounis, was a convertible-arbitrage specialist by background, but he had hired experts in merger arbitrage, long/short equity investing, credit arbitrage, and statistical arbitrage; and in 2002, following the collapse of the corrupt energy company Enron, Maounis had snapped up several stranded employees to open an energy-trading operation. Maounis made the standard arguments for this mission creep: A blend of alpha-generating strategies would diversify away risk, and Amaranth would move capital aggressively among strategies as market conditions shifted.


Concentrated Investing by Allen C. Benello

activist fund / activist shareholder / activist investor, asset allocation, barriers to entry, beat the dealer, Benoit Mandelbrot, Bob Noyce, business cycle, buy and hold, carried interest, Claude Shannon: information theory, corporate governance, corporate raider, delta neutral, discounted cash flows, diversification, diversified portfolio, Edward Thorp, family office, fixed income, high net worth, index fund, John von Neumann, Louis Bachelier, margin call, merger arbitrage, Paul Samuelson, performance metric, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, survivorship bias, technology bubble, transaction costs, zero-sum game

“After we bought it,” says Simpson, “it went on a very, very big run, returning 10 to 15 times GEICO’s investment.”86 Simpson also invested GEICO in a number of merger arbitrage deals, an investment strategy in which an investor, typically, simultaneously buys and sells the stocks of two merging companies in order to profit when the companies actually merge.87 Simpson, however, chose only to invest on the long side of these deals since he felt he could capture enough of the arbitrage that way. Simpson recalls that the 1980s, with the explosion of contested mergers and acquisition, were a particularly good time for merger arbitrage. GEICO invested in several of the food company takeovers after the deal was announced hoping that another bidder would top the offer.

GEICO invested in several of the food company takeovers after the deal was announced hoping that another bidder would top the offer. In the heated market, they often did. GEICO’s returns from merger arbitrage were excellent, in line with or even a little bit better than the remainder of the portfolio. As the decade wound on, however, Simpson became increasingly concerned that the takeovers were getting too heated, and he didn’t know if the market could sustain the torrid pace. Simpson believes he got lucky by declaring victory before GEICO had a disaster. After he stopped investing in merger Lou Simpson: The Disciplined Investor 15 arbitrage, there were many broken mergers in the lead up to the crash of 1987, and “we were darn lucky that we didn’t get a few bum deals.”88 While he disclaims any ability to predict macro factors, he has looked at valuation levels of the market as a whole.89 In 1987, before the crash, he also moved GEICO’s portfolio to approximately 50 percent in cash because he thought the valuation of the market was “outrageous.”90 Simpson says that the huge cash position “helped us for a while and then it hurt us,” because “we probably didn’t get back into the market as fast as we could have.”91 Simpson’s Results at GEICO [W]e try to exert a Ted Williams kind of discipline.


pages: 1,073 words: 302,361

Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan

asset-backed security, Bear Stearns, Bernie Madoff, business cycle, buttonwood tree, buy and hold, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, fear of failure, financial innovation, fixed income, Ford paid five dollars a day, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, John Meriwether, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, mega-rich, merger arbitrage, moral hazard, mortgage debt, Myron Scholes, paper trading, passive investing, Paul Samuelson, Ponzi scheme, price stability, profit maximization, risk tolerance, Ronald Reagan, Saturday Night Live, South Sea Bubble, tail risk, time value of money, too big to fail, traveling salesman, two and twenty, value at risk, yield curve, Yogi Berra, zero-sum game

In the latter instance, railroad bonds bought at a steep discount during the war would be worth a fortune. Cy Lewis had a great influence on Gus Levy. He encouraged Levy to trade in distressed railroad bonds and in other forms of arbitrage, including so-called block trading—the buying and selling of large blocks of stock, ideally at a profit—and in so-called merger arbitrage, which as Rohatyn described was the trading in the stocks of companies involved in corporate mergers, generally after the mergers had been announced publicly. Many institutional shareholders that owned the shares of companies involved in mergers often chose to sell those shares into the market—shares would trade up to near the offer price after a merger had been announced—since the time and risk involved in waiting often many months for a merger to close to get slightly more cash or stock was not generally worth doing.

They were willing to take the chance a deal might not close, or the financial consideration might change unfavorably, in the hope of making money on their bet. There were risks, of course—if they bought the stock of a company being taken over and then the deal failed to close, such a mistake could be devastating financially. But such mishaps were rare, and experts in the art of merger arbitrage did their best to avoid them. Why Cy Lewis would give away one valuable trading idea after another to a competitor—albeit someone who was also a friend—may never be known for sure. Perhaps it was just friendship, perhaps it helped create a market for the products Lewis was selling. In 1941, with the United States on the verge of entering World War II, Levy was anxious to see action.

.” —— AS LEVY SPENT more and more of his time running the firm and managing his extracurricular activities, Tenenbaum began to take on more responsibility and more initiative in building Goldman’s arbitrage business. One way that the arbitrage business became more complex was that as the M&A business began to pick up in the 1960s, Goldman would “arb” the deals by buying and selling stock in the companies involved in a deal—usually after the deal had been announced publicly. In this new frontier of merger arbitrage—known among arbitrageurs as “event driven” arbitrage—information was power and could mean the difference between making a lot of money or losing a lot of money. The people with the information about M&A deals were, of course, the people responsible for putting the deals together in the first place—the corporate executives, the investment bankers, and the lawyers—and arbitrageurs would think nothing of “making the call”—as arbs referred to the practice—to these groups of insiders to try to glean whatever bits of information they could that would give them a trading advantage.


pages: 257 words: 13,443

Statistical Arbitrage: Algorithmic Trading Insights and Techniques by Andrew Pole

algorithmic trading, Benoit Mandelbrot, constrained optimization, Dava Sobel, George Santayana, Long Term Capital Management, Louis Pasteur, mandelbrot fractal, market clearing, market fundamentalism, merger arbitrage, pattern recognition, price discrimination, profit maximization, quantitative trading / quantitative finance, risk tolerance, Sharpe ratio, statistical arbitrage, statistical model, stochastic volatility, systematic trading, transaction costs

The dearth of opportunity during 2002–2005 was not because of a greater number of practitioners or increasing assets managed in the strategy, both of which preceded the return decline, but because of the structural change in the economy. As 2005 drew to a close, anticipation was already building that merger activity would increase, resuscitating the merger arbitrage business, with just a few months of consistently positive economic news. Increased Trinity Troubles 161 participation in the business will have an impact on return as activity increases. The gains will be smaller on average; better, more experienced managers will do well if they discover and exploit the new patterns described in Chapter 11; neophytes, relying on traditional ideas, will have a more difficult time.

What is the difference between merger and statistical arbitrage such that massive structural change in the economy—caused by reactions to terrorist attacks, wars, and a series of corporate misdeeds—was accepted as temporarily interrupting the business of one but terminating it (a judgment now known to be wrong) for the other? Immensely important is an understanding of the source of the return generated by the business and the conditions under which that source pertains. The magic words ‘‘deal flow’’ echo in investor heads the moment merger arbitrage is mentioned. A visceral understanding provides a comfortable intellectual hook: When the economy improves (undefined—another internalized ‘‘understanding’’) there will be a resurgence in management interest in risk taking. Mergers and acquisitions will happen. The game will resume after an interlude.


pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

asset-backed security, backtesting, banking crisis, barriers to entry, Bear Stearns, beat the dealer, Bernie Madoff, Black-Scholes formula, British Empire, business cycle, buy and hold, buy the rumour, sell the news, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, computerized trading, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, Edward Thorp, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, intangible asset, James Dyson, Jones Act, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, money market fund, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, Right to Buy, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Rubik’s Cube, Savings and loan crisis, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

Wasn’t the fact that you had no experience at all in merger arbitrage an impediment to getting the job? Well, at $22,000, they clearly weren’t willing to spend much money and weren’t looking for an experienced analyst. I hoped they were just looking for someone with potential. What year was this? I started December 1981. Ironically, you began your career right before a major bottom in the stock market. It was interesting. At that time, not many people were looking to go to Wall Street because the market hadn’t gone up for 13 years. What were your experiences in your first job? At the time, merger arbitrage was the Wild West. There were great inefficiencies and plenty of opportunities, so that even a pedestrian year might be a 60 percent to 80 percent return.

At the time, merger arbitrage was the Wild West. There were great inefficiencies and plenty of opportunities, so that even a pedestrian year might be a 60 percent to 80 percent return. Was this just doing plain vanilla merger arbitrage? We did do straight risk arbitrage, and there were wide spreads available. But I was never that attracted to the risk/reward in risk arbitrage. In the Ben Graham approach, if you pay a cheap price for something, you have asymmetric returns on the upside because you can’t lose that much, but you still have large profit potential. Risk arbitrage is exactly the opposite. In risk arbitrage you’re trying to make $1 or $2 if the merger goes through, but risking $10 or $20 if the deal breaks.

See also Financial bubble of 2005–2007 Insurance Auto Auctions (IAAI) Intrinsic value Investment misconceptions Investors, pleasing James, Bill Jones, Paul Tudor Kassouf, Sheen Kellogg, Peter Kelly criterion Key3Media Keynes, John Maynard Kimmell, Emmanuel Klein, Joel Kovner, Bruce LEAPS Ledley, Charlie Lehman Brothers Lewis, Michael Liquidity vs. solvency The Little Book That Beats the Market (Greenblatt) Long, Simon Long Term Capital Management (LTCM) Long-term cycles LTCM (Long Term Capital Management) Macro outlook Madoff, Bernard Mai, Jamie Brazilian interest-rate trade investment strategy pillars subprime mortgages/bonds Manager selection Manalapan Oracle Capital Management Market behavior Marriott Mean reversion Measurement Specialties Merger arbitrage Micron Technology Milken, Michael Mistakes, learning from Mobius, Mark Monthly returns Mortgage-backed securities (MBSs). See also Subprime mortgages/bonds Moscowitz, Eva Net exposure indicator Net exposure ranges Net working capital Nevsky Fund Newberg, Bruce Newport Corporation New revenue sources News, market response to 9/11 Nomura Normal distribution assumption Obama, Barack October 1987 crash Omni Global Fund Optionality, free Options carry currencies vs.


pages: 620 words: 214,639

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan

asset-backed security, Bear Stearns, call centre, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Deng Xiaoping, diversification, Financial Instability Hypothesis, fixed income, Hyman Minsky, Irwin Jacobs, John Meriwether, Long Term Capital Management, margin call, merger arbitrage, money market fund, moral hazard, mortgage debt, mutually assured destruction, Myron Scholes, New Journalism, Northern Rock, Renaissance Technologies, Rod Stewart played at Stephen Schwarzman birthday party, Savings and loan crisis, savings glut, shareholder value, sovereign wealth fund, too big to fail, traveling salesman, Y2K, yield curve

Mayer and Joe Bear said, ‘Are you crazy?' And that was the end of Teddy Low's authority in that firm.” IN THE WAKE of his success betting on the railroad bonds and after he consolidated his power at the firm, Lewis needed an encore. Bear Stearns did, too. So the partners focused on other event-driven deals, such as merger arbitrage (betting on whether an announced merger would happen or not) and taking controlling equity stakes in companies. In effect, after World War II, Bear Stearns was at the starting line of what has come to be known as the private equity business. “What you're looking at,” Sandy Lewis said, “is how does the firm make money with money, the firm's money?”

In 1981, in the midst of DuPont's $7.5 billion acquisition of Conoco—then one of the largest acquisitions of all time and a bruising donnybrook between DuPont, Seagram, and Mobil—Robert Steinberg, who took over running risk arbitrage from Greenberg, had devised a trading strategy he described as “can't lose.” The problem was that Steinberg had reached the limit of the capital the firm had allocated to him for merger arbitrage investments. Greenberg would have to sign off on increasing that limit. Alan Schwartz, then head of the firm's small investment banking department, volunteered to speak to Greenberg on Steinberg's behalf. “I went to Ace, because it seemed as if we could do even better if we bought more,” Schwartz recalled years later.

To be sure, Marin's challenge was significant given that in 2003 BSAM was about 1 percent of the firm's revenues and a negative contributor to its profits. The first Bear Stearns—related phone call Marin received on his first day at the firm—even before he had made it to his office—came when Barry Cohen called his cell phone. Cohen had run the merger arbitrage fund at the firm for many years and made himself and his partners a bunch of money. Cohen had also been a protege of Bobby Steinberg, who oversaw the firm's risk function. Cohen was on the board of directors of Bear Stearns & Co., the firm's broker-dealer (as opposed to the Bear Stearns Companies, the public parent company).


pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, bond market vigilante , Bretton Woods, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, G4S, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stocks for the long run, survivorship bias, systematic trading, tail risk, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond, zero-sum game

Even here the boundaries are fuzzy, but I would say that the three premia—equity risk premium, bond risk premium, credit risk premium—accessed by static long-only holdings in traditional asset classes belong to the category of traditional betas. Examples of alternative (or HF) betas include the value, carry, momentum, and volatility strategies reviewed in this book as well as mechanical merger arbitrage or convertible arbitrage strategies. The demarcation line between alternative beta and alpha is especially blurry. I like a demarcation line that says that any static (average) exposure to a non-traditional factor is alternative beta, while any dynamic factor timing, other fine-tuning, or discretionary security selection is alpha.

Such approaches with static asset classes could only capture, in the rearview mirror, HFs’ recent average exposures. To better proxy HFs’ current exposures, some studies broadened the menu of factors to include nonlinear exposures (such as synthetic lookback options) and/or dynamic trading strategies (such as a trend-following proxy, merger arbitrage proxy, convertible arbitrage proxy). The in-sample fit to HF index and HF sector index returns can often be surprisingly good, but out-of-sample results less so. Such analyses show that, as a group, HFs often have significant risk exposures (albeit time varying) to equities, the small-cap premium, interest rates, and credits.

-realized volatility gap for volatility selling). For FX carry, the combination of carry dispersion and expected spot rate changes from value dispersion across currencies capture ex ante opportunity. Useful measures of ex ante opportunity also exist for certain hedge fund strategies, such as merger arbitrage or convertible arbitrage. However, for trend following and for general hedge fund investing there are no obvious value anchors. The relative importance of the three components varies across investments, often by construction. For example, the currency carry strategy earns nearly all of its long-run profits by being systematically long carry (buying high-yield currencies against selling low-yield currencies).


pages: 337 words: 89,075

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto

accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, John Meriwether, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low cost airline, market bubble, merger arbitrage, money market fund, new economy, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, price mechanism, purchasing power parity, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, Savings and loan crisis, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, stocks for the long run, survivorship bias, Tax Reform Act of 1986, the market place, transaction costs, Y2K, yield curve, zero-sum game

The manager uses short selling, but maintains a position in the neutral stock. Equity Market Neutral strategies attempt to exploit inefficiencies in the market through balanced overvalued securities buying and selling so that either a neutral-beta (that is, risk) or a neutral-dollar (that is, amounts invested) approach is obtained. Merger Arbitrage funds invest in companies involved in the mergersand-acquisitions process. Typically, they go long on targeted companies and sell short the acquiring companies. Relative Value strategies look to take advantage of the relative price differentials between related instruments. Short Selling strategies maintain a net or simple short exposure relative to the market.

Alpha Strategies 1997 1998 1999 2000 2001 2002 Convertible Arbitrage 14.81% 3.11% CTA Global 12.27% 14.30% 1.82% Distressed Securities 16.70% –2.26% 19.75% 4.81% 14.65% 5.86% 27.34% Emerging Markets 22.57% –26.66% 44.62% –3.82% 12.52% 5.76% Equity Market Neutral 15.43% 10.58% 13.15% 15.35% 8.18% 4.71% Event Driven 20.98% 1.00% 22.72% 9.04% 9.32% –1.08% 20.48% Fixed-Income Arbitrage 12.43% –8.04% 12.63% 5.70% 7.81% 7.56% Long/Short Equity 21.35% 14.59% 31.40% 12.01% –1.20% –6.38% 19.31% 16.08% 17.77% 13.78% 8.60% 7.32% 3.52% 2003 2004 Average Return Standard Deviation Sharpe Ratio 10.61% 6.09% 1.08 8.73% 5.01% 0.94 17.89% 12.73% 9.58% 0.91 31.27% 14.30% 10.56% 21.82% 0.30 6.29% 4.71% 4.49% 1.27 12.43% 11.54% 9.07% 0.83 6.26% 6.41% 6.45% 0.37 8.62% 11.87% 12.22% 0.64 10.80% 1.10% 14.57% 11.64% 8.35% 5.17% 9.72% Alpha Strategies 1997 1998 1999 2000 2001 Merger Arbitrage 17.44% 7.77% 17.97% 18.10% 2.87% Relative Value 16.51% 5.27% 17.15% 13.35% 8.63% Short Selling 3.07% 2002 2003 2004 Average Return Standard Deviation Sharpe Ratio –0.90% 8.34% 4.83% 9.33% 7.44% 0.72 2.77% 5.71% 10.08% 5.40% 1.13 20.76% –0.05 12.15% 27.07% –22.55% 22.80% 10.20% 27.27% –23.87% –4.66% 3.01% Chapter 14 Every Strategy Has Its Day Average Return 15.78% 4.25% 15.88% 11.13% 8.21% 6.25% 12.01% 6.94% 9.98% 4.36% 1.37 Funds of Funds 17.39% 4.20% 28.50% 7.84% 3.52% 1.26% 11.45% 7.08% 9.85% 8.98% 0.65 Hurdle Rate* 9.30% 10.44% 7.72% 5.76% 5.20% 5.54% 7.88% 9.67% 9.55% * The hurdle rate is defined as the average of one month LIBOR plus 400 basis points.


pages: 374 words: 114,600

The Quants by Scott Patterson

Albert Einstein, asset allocation, automated trading system, Bear Stearns, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Blythe Masters, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, Financial Modelers Manifesto, fixed income, Gordon Gekko, greed is good, Haight Ashbury, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Meriwether, John Nash: game theory, Kickstarter, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, money market fund, Myron Scholes, NetJets, new economy, offshore financial centre, old-boy network, Paul Lévy, Paul Samuelson, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Robert Mercer, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Savings and loan crisis, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

As other hedge funds sold indiscriminately in a broad, brutal deleveraging, Citadel snapped up bargains. Its Kensington fund gained 31 percent that year. By then, Citadel had more than $1 billion under management. The fund was diving into nearly every trading strategy known to man. In the early 1990s, it had thrived on convertible bonds and a boom in Japanese warrants. In 1994, it launched a “merger arbitrage” group that made bets on the shares of companies in merger deals. The same year, encouraged by Ed Thorp’s success at Ridgeline Partners, the statistical arbitrage fund he’d started up after shutting down Princeton/Newport, it launched its own stat arb fund. Citadel started dabbling in mortgage-backed securities in 1999, and plunged into the reinsurance business a few years later.

It posted a gain of 25 percent in 1998, 40 percent in 1999, 46 percent in 2000, and 19 percent in 2001, when the dot-com bubble burst, proving it could earn money in good markets and bad. Ken Griffin, clearly, had alpha. By then, Griffin’s fund was sitting on top of a cool $6 billion, ranking it among the six largest hedge funds in the world. Among his top lieutenants were Alec Litowitz, who ran the firm’s merger arbitrage desk, and David Bunning, head of global credit. In a few years, both Litowitz and Bunning would leave the fund. In 2005, Litowitz launched a $2 billion hedge fund called Magnetar Capital that would play a starring role in the global credit crisis several years later. A magnetar is a neutron star with a strong magnetic field, and Litowitz’s hedge fund turned out to have a strong attraction for a fast-growing crop of subprime mortgages.


pages: 403 words: 119,206

Toward Rational Exuberance: The Evolution of the Modern Stock Market by B. Mark Smith

bank run, banking crisis, business climate, business cycle, buy and hold, capital asset pricing model, compound rate of return, computerized trading, credit crunch, cuban missile crisis, discounted cash flows, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, full employment, income inequality, index arbitrage, index fund, joint-stock company, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market clearing, merger arbitrage, money market fund, Myron Scholes, Paul Samuelson, price stability, random walk, Richard Thaler, risk free rate, risk tolerance, Robert Bork, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, stocks for the long run, the market place, transaction costs

The arbitrage necessary to keep markets efficient attempts to capitalize on pricing discrepancies created by irrational investors. Simply put, the arbitrageurs sell short stocks that are overpriced and buy stocks that are underpriced, until “irrational” prices are brought back into line. Unlike index arbitrage or merger arbitrage, however, efforts to arbitrage broad market mispricings suffer from an inherent lack of specific events that create a date-certain at which the arbitrageur can cash in his position. The index arb who sells equity index futures versus buying index stocks knows that he will be able to unwind his position when the futures contract expires.

To liquidate his position at that time, he sells his stocks at the expiration day’s closing prices (the so-called witching hour), knowing that he will also be cashed out of his futures contracts based on the same closing prices. Likewise, the merger arbitrageur unwinds his position when the merger he is betting on is consummated. While there is more risk in the merger arbitrage than the index arbitrage, in both instances the arbitrageurs have a specific time horizon over which their bets will be paid off. The market participant who attempts to arbitrage other types of mispricings has no such advantage. For example, if he thinks that technology stocks are expensive compared with “old economy” stocks, he can sell short technology stocks and buy “old economy” stocks.


pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black-Scholes formula, business cycle, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, John Meriwether, Kickstarter, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sam Peltzman, Savings and loan crisis, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, systematic trading, tail risk, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

Even if LTCM had survived, the trade would not have made money for them, though their losses would have been much more manageable.30 The 1998 risk models didn’t include crowd interconnectedness or the price of liquidity during a crisis. Risk Arbitrage Trades Risk arbitrage, also known as merger arbitrage, is a trading strategy used by many hedge funds. In this strategy a trader invests in companies going through a merger, spinoff, acquisition, or similar event. The most typical trade begins when two companies announce their merger (or similar event). Risk arbitrage attempts to profit from the merger’s completion or failure.

LTCM’s portfolio was down 2.11%, or about $78 million, on the day that Russia defaulted. LTCM’s historical profit-and-loss volatility on any given day was about $38 million, so this was a big dip. The next few days brought a string of smaller losses. Extreme losses began on Friday, August 21, when LTCM lost $552 million, $160 million of that on a merger arbitrage play—the Ciena Tellabs merger—that fell short. On the following Monday, the firm lost another $220 million. On Tuesday, it shed $129 million. LTCM’s losses seemed to be a symptom, one caused by crowds of other traders unwinding positions similar to the firm’s favored investments. LTCM lost money on 14 of 18 business days from July 22, 1998, to August 14, 1998.

See Long-term Capital Management Mack, John Madoff Securities Market prices, as endogenous Market risk Mark-to-market accounting Marron, Donald Matched-book funding Matthews, Paul Mattone, Vinny Maturity transformation Maughan, Deryck Maxwell, David Mayer, Jeff MBS (mortgage-backed securities) McCarthy, Lawrence McCulley, Paul McDade, Herbert (Bart) McDonald, Lawrence McDonough, William McEntee, James McGee McHale, Sharon Measuring risk Media and housing bubble Mellon Bank Merger arbitrage trades Meriwether, John: career of on crowding on financial insurance as financial pioneer JWM Partners and letter by at LTCM on post-Lehman period at Salomon Brothers on 2008 Merrill Lynch: Bank of America and Bear Stearns and liquidity stress test results real estate exposure Merton, Robert Metallgesellschaft, collapse of Meyer, William MF Global Min, Euoo Sung Modest, David Molinaro, Samuel Money market products Moody’s Investors Service, Inc.


pages: 413 words: 117,782

What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences by Steven G. Mandis

activist fund / activist shareholder / activist investor, algorithmic trading, Bear Stearns, Berlin Wall, bonus culture, BRICs, business process, buy and hold, collapse of Lehman Brothers, collateralized debt obligation, commoditize, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, eat what you kill, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, Myron Scholes, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, Satyajit Das, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk

For example, if it were a cross-border M&A deal, then Goldman would provide M&A advice as well as involve its foreign exchange desk to handle the currency exchange for the purchase price. If Goldman missed the deal—meaning our bankers were not involved—then proprietary trading might possibly be involved in merger arbitrage (oftentimes, Goldman would make more money in proprietary merger arbitrage than if it had been hired to advise on the deal). Goldman ensured that we looked at each transaction and each flow and had some way to make money from it. The more roles we played in a transaction, the more opportunities we had to make money on a cost base that was essentially fixed, and thus the transaction would be much more profitable for us than if we had played only one role.


pages: 505 words: 142,118

A Man for All Markets by Edward O. Thorp

3Com Palm IPO, Albert Einstein, asset allocation, Bear Stearns, beat the dealer, Bernie Madoff, Black Swan, Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, caloric restriction, caloric restriction, carried interest, Chuck Templeton: OpenTable:, Claude Shannon: information theory, cognitive dissonance, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Edward Thorp, Erdős number, Eugene Fama: efficient market hypothesis, financial innovation, Garrett Hardin, George Santayana, German hyperinflation, Henri Poincaré, high net worth, High speed trading, index arbitrage, index fund, interest rate swap, invisible hand, Jarndyce and Jarndyce, Jeff Bezos, John Meriwether, John Nash: game theory, Kenneth Arrow, Livingstone, I presume, Long Term Capital Management, Louis Bachelier, margin call, Mason jar, merger arbitrage, Murray Gell-Mann, Myron Scholes, NetJets, Norbert Wiener, passive investing, Paul Erdős, Paul Samuelson, Pluto: dwarf planet, Ponzi scheme, price anchoring, publish or perish, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, RFID, Richard Feynman, risk-adjusted returns, Robert Shiller, Robert Shiller, rolodex, Sharpe ratio, short selling, Silicon Valley, Stanford marshmallow experiment, statistical arbitrage, stem cell, stocks for the long run, survivorship bias, tail risk, The Myth of the Rational Market, The Predators' Ball, the rule of 72, The Wisdom of Crowds, too big to fail, Tragedy of the Commons, Upton Sinclair, value at risk, Vanguard fund, Vilfredo Pareto, Works Progress Administration

Over a period of several years, he expected each of these investments to substantially outperform the market, as represented by an index such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500). As his mentor Ben Graham did before him, Warren also invested in warrant and convertible hedging and merger arbitrage. It was in this area that his and my interest overlapped, and where Buffett, unknown to me, was vetting me as a possible successor to manage investments for the Gerards. As we chatted about compound interest, Warren gave one of his favorite examples of its remarkable power, how if the Manhattan Indians could have invested $24, the value then of the trinkets Peter Minuit paid them for Manhattan in 1626, at a net return of 8 percent, they could buy the land back now along with all the improvements.

If the total cost to finance the deal and to insure and deliver the New York gold to London were $5, it would leave a $5 sure profit. That’s an arbitrage in its original usage. Later the term was expanded to describe investments where risks are expected to be largely offsetting, with a profit that is likely, if not certain. For instance, in what is called merger arbitrage, company A trading at $100 a share may offer to buy company B, trading at $70 a share, by exchanging one share of company A for each share of company B. The market reacts instantly and company A’s shares drop to, say, $88 while company B’s shares jump to $83. Merger arbitrageurs now step in, buying a share of B at $83 and selling short a share of A at $88.


How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Bear Stearns, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business cycle, business process, butter production in bangladesh, buy and hold, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Stallman, risk free rate, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

In “A Tale of Two Hedge Funds,” Ken and I describe in detail how the supposedly low-risk strategies of LTCM and another infamous hedge fund, Granite, came apart in spectacular fashion when they had exhausted the market’s liquidity. “A Tale of Two Hedge Funds” appears in our edited volume, Market Neutral Strategies ( 2005), which brought together some of the industry’s most successful practitioners to discuss longshort equity strategies, convertible bond hedging, and merger arbitrage, as well as sovereign fixed income and mortgage arbitrage. It serves as a cautionary reminder of how such strategies, when not managed carefully, can blow up, threatening the very markets in which they operate. I had taken the liberty of sending a draft of Capital Ideas and Market Realities to Nobel laureate Harry Markowitz, who not only liked the work, but offered to write the foreword to the book.

Tanya Styblo Beder has built three businesses during her 20-year career in the global capital markets. Beginning in 2004, Ms. Beder designed and built as its CEO Tribeca Global Management LLC, Citigroup’s multistrategy hedge. As CEO, she also was responsible for several other institutional fund offerings including convertibles, distressed debt, merger arbitrage, and credit. Beginning in 1999, she built the Strategic Quantitative Investment Division (SQID) of Caxton Associates LLC. Before her roles in the hedge fund industry, Ms. Beder founded two consulting firms specializing in risk measurement, risk oversight, capital markets and derivatives—Capital Market Risk Advisors in 1994 and SB Consulting Corp. in 1987.


pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Bear Stearns, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, business cycle, buy the rumour, sell the news, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Fall of the Berlin Wall, financial independence, financial innovation, financial thriller, fixed income, foreign exchange controls, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", job automation, Johann Wolfgang von Goethe, John Meriwether, joint-stock company, Jones Act, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Mikhail Gorbachev, Milgram experiment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, National Debt Clock, negative equity, NetJets, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Thaler, Right to Buy, risk free rate, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, Satyajit Das, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, survivorship bias, tail risk, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, the new new thing, The Predators' Ball, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, two and twenty, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

Inflow of money into successful hedge funds eroded returns. Louis Bacon (of Moore Capital) observed: “Size matters. It is the bane of the successful money manager.”5 Size forces style drift. LTCM drifted from its métier, relative value trading in fixed income, into volatility trading, credit spread trading, and merger arbitrage. In 2006, when market neutral hedge funds losses mirrored the fall in the market, hedge fund managers explained: “Everything in the market was a compelling buy. We could find nothing to short.” The market changed. Banks cloned hedge funds, replicating returns by using simple instruments, with lower fees and less risk of an Amaranth or LTCM.6 Investors were looking for grand masters at knock-off prices.

In a weakening economic environment, hedge funds believed that VW shares were overvalued and bet that the share price would fall. As Porsche’s share purchases and option activity pushed up VW’s share price, hedge funds sold VW shares short, looking to buy them back when the price fell. Some funds sold VW shares and bought the shares of other car companies to capture the correction in relative prices. Merger arbitrage funds sold VW shares and bought Porsche shares, betting that the prices would converge. Others shorted VW ordinary shares and bought the preference shares trading at a 50 percent discount to ordinary shares, betting that the spread would decrease. Around September 2009, Porsche announced it intended to lift its shareholding to 75 percent, allowing it to enter into a domination agreement, giving it effective control of VW.


pages: 733 words: 179,391

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

"Robert Solow", Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Bear Stearns, Berlin Wall, Bernie Madoff, bitcoin, Bonfire of the Vanities, bonus culture, break the buck, Brownian motion, business cycle, business process, butterfly effect, buy and hold, capital asset pricing model, Captain Sullenberger Hudson, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, Diane Coyle, diversification, diversified portfolio, double helix, easy for humans, difficult for computers, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, interest rate derivative, invention of the telegraph, Isaac Newton, James Watt: steam engine, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, merger arbitrage, meta-analysis, Milgram experiment, money market fund, moral hazard, Myron Scholes, Nick Leeson, old-boy network, out of africa, p-value, paper trading, passive investing, Paul Lévy, Paul Samuelson, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Shiller, Sam Peltzman, Savings and loan crisis, Shai Danziger, short selling, sovereign wealth fund, Stanford marshmallow experiment, Stanford prison experiment, statistical arbitrage, Steven Pinker, stochastic process, stocks for the long run, survivorship bias, Thales and the olive presses, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

SMART BETA VERSUS DUMB SIGMA A growing number of dynamic indexes use specific investment strategies, systematically and without human intervention. For example, in 2008, equity analyst Pankaj Patel and I created a dynamic index for the strategy underlying a “130/30” equity fund, which uses leverage to invest 130 percent in long positions and 30 percent in short positions.9 Even esoteric hedge fund strategies such as merger arbitrage—betting on publicly announced corporate mergers—are now available to the average investor through dynamic indexes. The theory underpinning these dynamic indexes is straightforward enough, flowing naturally from variations on the original CAPM formulation, using factors in addition to the market portfolio to estimate and invest in linear risk/reward relationships.

., 300 McAuliffe, Christa, 12 McCulloch, Warren, 131 McDonald, Lawrence, 317 McClure, Samuel, 99 McCrea, Sean M., 65 McGuire, Joseph T., 100 McQuown, John A., 263 Mean Genes (Burnham), 337 mean reversion, 286, 292, 324–326 Medallion Fund, 6 “ME HURT YOU” narrative, 339–340, 341, 343, 345 Melanesia, 151–152 memory, 130 merger arbitrage, 267 Meriwether, John, 241 Merrill Lynch, 242–243, 306, 308, 309 Merton, Robert C., 27, 127, 266, 356–357; financial engineering innovations by, 211; housing crisis viewed by, 322–323; at Long-Term Capital Management, 241; network contagion viewed by, 376–377; Nobel Prize awarded to, 97. See also Black-Scholes/Merton option pricing formula mescaline, 79 meta-analysis, 100 Metallgesellschaft, 320, 321 method acting, 105 Microsoft Windows, 372 Milgram, Stanley, 346, 347 Mill, John Stuart, 211 Milner, Peter, 87 Minnesota Center for Twin and Family Research, 159 Minsky, Marvin, 132–133 mirror neuron, 110, 157 miscarriages, 152 Mischel, Walter, 120–121 mobile banking, 356 money market funds, 228, 300, 301, 409 Moffitt, Terrie, 160 Montague, Read, 97, 98 Moore, Gordon, 356 Moore, Jesse W., 12 Moore’s Law, 356, 358, 385 Morgan Stanley, 235–237, 240, 284, 286, 307, 308 Morgenbesser, Sidney, 46–47 morphine, 89, 90 Morse, Adair, 353–354 mortgages, 7, 290, 292, 293, 297–329, 376, 377, 410 Morton Thiokol Inc., 13–16 Mossin, Jan, 263 motor control, 153 MSCI World Index, 251 Mulherin, J.


The Handbook of Personal Wealth Management by Reuvid, Jonathan.

asset allocation, banking crisis, BRICs, business cycle, buy and hold, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, market bubble, merger arbitrage, negative equity, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, Right to Buy, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

Table 1.3.1 Performance of hedge fund indices in 2008 Strategy Net of fees year to date returns to 31 Oct 08 (USD) HFRI Fund Weighted Composite Index HFRI Equity Hedge (Total) Index HFRI EH: Equity Market Neutral Index HFRI EH: Quantitative Directional HFRI EH: Short Bias Index HFRI Event-Driven (Total) Index HFRI ED: Merger Arbitrage Index HFRI Macro (Total) Index HFRI Relative Value (Total) Index HFRI RV: Fixed Income–Asset Backed HFRI RV: Fixed Income–Convertible Arbitrage Index HFRI RV: Fixed Income–Corporate Index HFRI RV: Multi–Strategy Index –15.48 –22.49 –3.78 –19.04 21.18 –16.66 –5.37 5.55 –17.11 0.07 –35.06 –18.32 –20.69 ________________________________________________ HEDGE FUND STRATEGIES 33 ឣ Discretionary macro Discretionary macro is one of the few strategies that has posted positive performance in the year to date (end October 2008).


pages: 253 words: 79,214

The Money Machine: How the City Works by Philip Coggan

activist fund / activist shareholder / activist investor, algorithmic trading, asset-backed security, Bear Stearns, Bernie Madoff, Big bang: deregulation of the City of London, bond market vigilante , bonus culture, Bretton Woods, call centre, capital controls, carried interest, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, disintermediation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, endowment effect, financial deregulation, financial independence, floating exchange rates, foreign exchange controls, Hyman Minsky, index fund, intangible asset, interest rate swap, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", joint-stock company, labour market flexibility, large denomination, London Interbank Offered Rate, Long Term Capital Management, merger arbitrage, money market fund, moral hazard, mortgage debt, negative equity, Nick Leeson, Northern Rock, pattern recognition, purchasing power parity, quantitative easing, reserve currency, Right to Buy, Ronald Reagan, shareholder value, South Sea Bubble, sovereign wealth fund, technology bubble, time value of money, too big to fail, tulip mania, Washington Consensus, yield curve, zero-coupon bond

Most shareholders wait until the last minute before deciding, in case a higher bid is put on the table. The final count can be agonizingly close – bids have been disallowed because the vital acceptances were delivered just a few minutes after the final deadline. These days hedge funds may often be involved. Some may follow a strategy known as merger arbitrage in which they buy the shares of the target and sell short (bet on a decline in) the shares of the predator. Others may be activist funds that buy stakes and try to force a company’s managers to increase the share price by seeking a bid. Takeovers tend to be terribly acrimonious, although the kind of high-profile advertising that characterized the takeover battles of the early 1980s has been discouraged.


Work Less, Live More: The Way to Semi-Retirement by Robert Clyatt

asset allocation, backtesting, buy and hold, delayed gratification, diversification, diversified portfolio, eat what you kill, employer provided health coverage, estate planning, Eugene Fama: efficient market hypothesis, financial independence, fixed income, future of work, independent contractor, index arbitrage, index fund, lateral thinking, Mahatma Gandhi, McMansion, merger arbitrage, money market fund, mortgage tax deduction, passive income, rising living standards, risk/return, Silicon Valley, The Theory of the Leisure Class by Thorstein Veblen, Thorstein Veblen, transaction costs, unpaid internship, upwardly mobile, Vanguard fund, working poor, zero-sum game

The “Market Neutral” moniker is a catchall for a number of different hedge fund strategies that use esoteric methods to seek profits uncorrelated to stock and bond markets. Several investment strategies are generally grouped under this heading— including index arbitrage, convertible-warrant hedging, merger arbitrage, interest rate arbitrage, Long-Short strategies, and others. 336 | Work Less, Live More Invest in these hedging strategies via a handful of mutual funds including the well-established Diamond Hill Long-Short Fund (DHFCX) and the Merger Fund (MERFX), as well as in the smaller Arbitrage Fund (ARBFX), Rydex Absolute Return (RYMSX), or James Advantage Market Neutral (JAMNX).


pages: 417 words: 97,577

The Myth of Capitalism: Monopolies and the Death of Competition by Jonathan Tepper

Affordable Care Act / Obamacare, air freight, Airbnb, airline deregulation, bank run, barriers to entry, Berlin Wall, Bernie Sanders, big-box store, Bob Noyce, business cycle, Capital in the Twenty-First Century by Thomas Piketty, citizen journalism, Clayton Christensen, collapse of Lehman Brothers, collective bargaining, compensation consultant, computer age, corporate raider, creative destruction, Credit Default Swap, crony capitalism, diversification, don't be evil, Donald Trump, Double Irish / Dutch Sandwich, Edward Snowden, Elon Musk, en.wikipedia.org, eurozone crisis, Fall of the Berlin Wall, family office, financial innovation, full employment, German hyperinflation, gig economy, Gini coefficient, Goldman Sachs: Vampire Squid, Google bus, Google Chrome, Gordon Gekko, Herbert Marcuse, income inequality, independent contractor, index fund, Innovator's Dilemma, intangible asset, invisible hand, Jeff Bezos, John Nash: game theory, John von Neumann, Joseph Schumpeter, Kenneth Rogoff, late capitalism, London Interbank Offered Rate, low skilled workers, Mark Zuckerberg, Martin Wolf, means of production, merger arbitrage, Metcalfe's law, multi-sided market, mutually assured destruction, Nash equilibrium, Network effects, new economy, Northern Rock, offshore financial centre, passive investing, patent troll, Peter Thiel, Plutocrats, plutocrats, prediction markets, prisoner's dilemma, race to the bottom, rent-seeking, road to serfdom, Robert Bork, Ronald Reagan, Sam Peltzman, secular stagnation, shareholder value, Silicon Valley, Skype, Snapchat, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, The Chicago School, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, too big to fail, undersea cable, Vanguard fund, very high income, wikimedia commons, William Shockley: the traitorous eight, you are the product, zero-sum game

Greed, in all of its forms – greed for life, for money, for love, knowledge – has marked the upward surge of mankind. And greed – you mark my words – will not only save Teldar Paper, but that other malfunctioning corporation called the USA. The bond market boomed, and Wall Street provided financing to corporate raiders who bought companies. Speculating on deals promised vast riches, and merger arbitrage became one of the most profitable trading strategies on Wall Street. It spawned a cottage industry of insider trading on merger tips. Men like Ivan Boesky were kings of Wall Street, until the SEC arrested him and others in insider trading rings. Regulators no longer cared about mergers, and the only thing that brought the merger wave to an end was the recession of 1990–1991 and the stock market decline.


pages: 367 words: 97,136

Beyond Diversification: What Every Investor Needs to Know About Asset Allocation by Sebastien Page

Andrei Shleifer, asset allocation, backtesting, Bernie Madoff, bitcoin, Black Swan, business cycle, buy and hold, Cal Newport, capital asset pricing model, coronavirus, corporate governance, Covid-19, COVID-19, cryptocurrency, discounted cash flows, diversification, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, fixed income, future of work, G4S, implied volatility, index fund, information asymmetry, iterative process, loss aversion, market friction, mental accounting, merger arbitrage, oil shock, passive investing, prediction markets, publication bias, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Feynman, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, sovereign wealth fund, stochastic process, stochastic volatility, stocks for the long run, systematic trading, tail risk, transaction costs, value at risk, yield curve, zero-coupon bond, zero-sum game

In Table 9.1, Rob and I used a broad hedge fund index, but one could argue that hedge fund styles are so different from each other that they should be treated as separate asset classes. We decided to compare left-tail and right-tail correlations (versus US stocks) for seven hedge fund styles: equity market neutral, merger arbitrage, event driven, macro, equity hedge, relative value convertible, and relative value. Unfortunately, we found that all these types of hedge funds, including the market-neutral funds, exhibited significantly higher left-tail than right-tail correlations. While the average right-tail correlation was –7%, the average left-tail correlation jumped to +63%.10 A simple explanation could be that most hedge fund strategies are short volatility.


pages: 369 words: 107,073

Madoff Talks: Uncovering the Untold Story Behind the Most Notorious Ponzi Scheme in History by Jim Campbell

algorithmic trading, Bear Stearns, Bernie Madoff, delta neutral, family office, fear of failure, financial thriller, fixed income, forensic accounting, full employment, Gordon Gekko, high net worth, index fund, margin call, merger arbitrage, money market fund, mutually assured destruction, offshore financial centre, Ponzi scheme, Renaissance Technologies, risk free rate, riskless arbitrage, Sharpe ratio, short selling, sovereign wealth fund, time value of money, two and twenty, walking around money

Bernie knew Picower had a history of shady dealings, yet he lacked the moral compass and backbone to avoid doing business with him. Without Picower, the Ponzi scheme wouldn’t have survived for as long as it did. In the process, Bernie became beholden to him. Picower seemed to pick up his investment gains or evade taxes in any way he could. Along with the reported $28 million he invested in Boesky’s insider-trading merger arbitrage fund, he had a history of lawsuits, as well as involvement in questionable tax shelter schemes. In one minor lawsuit, for someone with a net worth in the billions, Picower had been sued for not paying a contractor, refusing to pay for work done on his New York office, claiming the job was so botched the toilets didn’t flush properly.


pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Bear Stearns, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy and hold, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disinformation, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, new economy, New Journalism, Nick Leeson, Nixon triggered the end of the Bretton Woods system, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, Right to Buy, risk free rate, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

DAS_Z01.QXP 8/11/06 310 2:10 PM Page 310 Tr a d e r s , G u n s & M o n e y The absence of opportunities created ‘style drift’: hedge funds with certain areas of expertise began to trade in other markets. LTCM, too, had drifted from their metier – relative value trading in fixed income – into volatility trading, credit spread trading and merger arbitrage. Hedge funds are not noted for their transparency. Lack of disclosure means that you don’t know how far the ship is off course until it is on the rocks. Cases of fraud and other common crimes also began to surface. There was every sign that the hedge fund universe was overheated. At the suggestion that there was a ‘bubble’, one manager bristled that hedge funds weren’t an ‘asset class’, therefore there was no ‘bubble’ to burst.


pages: 598 words: 169,194

Bernie Madoff, the Wizard of Lies: Inside the Infamous $65 Billion Swindle by Diana B. Henriques

accounting loophole / creative accounting, airport security, Albert Einstein, banking crisis, Bear Stearns, Bernie Madoff, break the buck, British Empire, buy and hold, centralized clearinghouse, collapse of Lehman Brothers, computerized trading, corporate raider, diversified portfolio, Donald Trump, dumpster diving, Edward Thorp, financial deregulation, financial thriller, fixed income, forensic accounting, Gordon Gekko, index fund, locking in a profit, mail merge, merger arbitrage, money market fund, Plutocrats, plutocrats, Ponzi scheme, Potemkin village, random walk, Renaissance Technologies, riskless arbitrage, Ronald Reagan, Savings and loan crisis, short selling, Small Order Execution System, source of truth, sovereign wealth fund, too big to fail, transaction costs, traveling salesman

It could be as simple as ordering cartons of cigarettes by telephone from a vendor in a low-cost state and simultaneously selling them over the phone at a higher price in states where they are more expensive, thereby locking in a profit. Or it could be as complex as using computer software to instantly detect a tiny price differential for a stock trading in two different currencies and execute the trades without human intervention—again, locking in the profit. What distinguished riskless arbitrage from the more familiar “merger arbitrage” of the 1980s—which involved speculating in the securities of stocks involved in possible takeovers—was that a profit could be captured the moment it was perceived, if the trade could be executed quickly enough. A conventional trader would buy a security in hopes of selling it later at a profit; if he guessed wrong, he lost money.


pages: 1,336 words: 415,037

The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

affirmative action, Albert Einstein, anti-communist, Ayatollah Khomeini, barriers to entry, Bear Stearns, Bob Noyce, Bonfire of the Vanities, Brownian motion, capital asset pricing model, card file, centralized clearinghouse, Charles Lindbergh, collateralized debt obligation, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, Donald Trump, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, Garrett Hardin, global village, Golden Gate Park, Haight Ashbury, haute cuisine, Honoré de Balzac, If something cannot go on forever, it will stop - Herbert Stein's Law, In Cold Blood by Truman Capote, index fund, indoor plumbing, intangible asset, interest rate swap, invisible hand, Isaac Newton, Jeff Bezos, John Meriwether, joint-stock company, joint-stock limited liability company, Long Term Capital Management, Louis Bachelier, margin call, market bubble, Marshall McLuhan, medical malpractice, merger arbitrage, Mikhail Gorbachev, money market fund, moral hazard, NetJets, new economy, New Journalism, North Sea oil, paper trading, passive investing, Paul Samuelson, pets.com, Plutocrats, plutocrats, Ponzi scheme, Ralph Nader, random walk, Ronald Reagan, Scientific racism, shareholder value, short selling, side project, Silicon Valley, Steve Ballmer, Steve Jobs, supply-chain management, telemarketer, The Predators' Ball, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, Tragedy of the Commons, transcontinental railway, two and twenty, Upton Sinclair, War on Poverty, Works Progress Administration, Y2K, yellow journalism, zero-coupon bond

The boyish Rosenfeld, forty-five years old and one of Meriwether’s key lieutenants, was the person who had had the brain-numbing job of going through thousands of Mozer’s trades at Salomon and reconstructing what went wrong. Buffett liked Rosenfeld. Now he had been deputized by Meriwether to cut back the portfolio’s size by selling the firm’s merger arbitrage positions. “I hadn’t heard from him for years. With fear in his voice, Eric started to talk about me taking out their whole big stock arbitrage position, six billion dollars’ worth. They thought stock arbitrage was mathematical.”22 Responding reflexively, Warren Buffetted Rosenfeld. “I just said to Eric, I would take certain ones but not all of them.”

Shorting it as a collection of stocks would not work because of a basis mismatch between Berkshire and the offsetting hedgeable positions. Berkshire was a collection of wholly owned businesses fueled by an insurance company that also owned some stocks, not a quasi-mutual fund. 21. Roger Lowenstein, When Genius Failed. 22. Stock or merger arbitrage is a bet on whether a merger will close. Merger-arb specialists talk to lawyers and investment bankers and specialize in scuttlebutt. Their bets are based partly on knowledge about a deal, not just statistics about how typical deals have done. 23. Interview with Eric Rosenfeld; Lowenstein, When Genius Failed. 24.


pages: 670 words: 194,502

The Intelligent Investor (Collins Business Essentials) by Benjamin Graham, Jason Zweig

3Com Palm IPO, accounting loophole / creative accounting, air freight, Andrei Shleifer, asset allocation, business cycle, buy and hold, buy low sell high, capital asset pricing model, corporate governance, corporate raider, Daniel Kahneman / Amos Tversky, diversified portfolio, dogs of the Dow, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, George Santayana, hiring and firing, index fund, intangible asset, Isaac Newton, Long Term Capital Management, market bubble, merger arbitrage, money market fund, new economy, passive investing, price stability, Ralph Waldo Emerson, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, sharing economy, short selling, Silicon Valley, South Sea Bubble, Steve Jobs, stocks for the long run, survivorship bias, the market place, the rule of 72, transaction costs, tulip mania, VA Linux, Vanguard fund, Y2K, Yogi Berra

Here, however, Graham means “net working-capital value,” or the per-share value of current assets minus total liabilities. * Le coeur a ses raisons que la raison ne connaît point. This poetic passage is one of the concluding arguments in the great French theologian’s discussion of what has come to be known as “Pascal’s wager” (see commentary on Chapter 20). * As discussed in the commentary on Chapter 7, merger arbitrage is wholly inappropriate for most individual investors. 1 Patricia Dreyfus, “Investment Analysis in Two Easy Lessons” (interview with Graham), Money, July, 1976, p. 36. 2 See the commentary on Chapter 11. 3 There are also many newsletters dedicated to analyzing professional portfolios, but most of them are a waste of time and money for even the most enterprising investor.