Hedge Fund Market Wizards: A Conversation With Jack Schwager

Best selling author, Jack D. Schwager, discusses how winning traders win

John Nyaradi: Hi, I am John Nyaradi, Publisher of Wall Street Sector Selector, a financial web site specializing in global economic analysis and exchange traded funds. Today it’s my pleasure to introduce our special guest, Jack Schwager. Jack is the best selling author of the classic “Market Wizards” and now he has a new book out titled “Hedge Fund Market Wizards: How Winning Traders Win.” Jack, welcome to Wall Street Sector Selector.

Jack Schwager: Thanks John

John Nyaradi: Let’s start with why did you write the book? What do you want people to get out of it?

Jack Schwager: Sure, it’s been quite awhile since I did a Market Wizard book. And there were a lot of traders out there who deserved similar coverage. I also wanted to focus on traders who had achieved a very good return to risk as opposed to just looking at total return numbers.

John Nyaradi: You talk about a wide variety of different strategies in the book. Could you touch on some of the trading styles and strategies you saw.

Jack Schwager: Yes, that was the great thing about this project. If I were making up 15 different strategies to try to sound as different as I could, I couldn’t make up 15 more diverse traders than the people I ended up with in this book. They are at completely opposite spectrums in multiple dimensions. So there is really no typical style; there is no typical approach; there is no typical market; there is no typical length of trading. They just really are all over the place in terms of the strategies. Each trader has his own insight; each trader has his own story.

John Nyaradi: Let’s talk about a couple of things retail investors hear all the time, that is, we should “buy and hold,” and that you “can’t beat the market.”

Jack Schwager: Well, buy and hold works well during certain phases of time. You can get 20-30 year periods when buy and hold is very good, but you can also get 20-30 year periods when it’s not. If you used buy and hold in 1928-29, it would have taken you 20-30 years to get back to even. And then it is not just the US. If you look at Japan, for example, people who used buy and hold in the 80s would still be way underwater 25 years later.

So there are many, many examples where buy and hold really ends up being a very poor strategy—situations where you end up going sideways while you get 25 years worth of inflation, and so in real dollar terms, you’re much worse off.

But what I would say that I believe is true is that buy and hold can be a good strategy if you buy after a period when the market has done poorly and then hold for a very long time. So if you are young and you get a period like 2008, or any period after the market sells off substantially, and that’s when you buy–when everybody hates stocks–and then you hold for the long term, that will probably work out just fine.

The real danger is adapting a buy and hold type of strategy after everybody feels really great about stocks–a period like at the end of 90s. That’s when it could be a terrible strategy. So those are my views on buy and hold.

Now as far as “you can’t beat the market,” there is a big difference between saying the markets are very difficult to beat and the thought that you can’t beat the markets. I can actually mathematically demonstrate that they can be beaten. Clearly there are people who do beat the markets beyond any mathematical shadow of a doubt, and so it can be done. Is it difficult? Absolutely. Can most people do it? Probably not. But, can it be done? In my opinion, yes it can.

John Nyaradi: Let’s talk about return and risk. Most people go into an investment thinking about how much they can make, not really thinking too much about risk. How do you look at those two concepts?

Jack Schwager: Sure, I am glad you put the question that way. Most people do it exactly the wrong way: They worry about how much they can make instead of worrying about what they might lose. If you go through the interviews in my book, you will see that the mentality is more “How do I avoid losing?” and, only secondarily, “How do I make money?”

Too many people are focused on return. Return alone can be a very misleading measure because, very simplistically, anybody can double returns by just doubling exposure. If you take twice as much risk, you will make twice the return, but that doesn’t mean you are twice as smart or twice as good. You are exactly where you were before because your risk is now doubling as well. So I always look at return to risk, and in the book I have my own measure of return to risk, which I call a gain-to-pain ratio. The gain-to-pain ratio is simply the sum of all the monthly returns divided by the sum of all the monthly losses. It gives you a good feel for how good a manager really is because you are not only looking at all the returns, but you are also looking at all the losses that were realized in getting that return.

John Nyaradi: Let’s talk about volatility. Today’s volatility is scaring a lot of people. What’s your view on that?

Jack Schwager: Well, people shouldn’t be scared of volatility. Volatile times are often high opportunity times. The other aspect that came up in a number of interviews is that traders don’t maintain constant position size. They will trade less aggressively when markets are very volatile. In at least two of the interviews, the traders talked about how they sharply cut their position size in 2008 because the markets were so much more volatile.

You always have to trade within your comfort level, and if you are trading at a comfort level and the market gets much more volatile, then by definition, you will no longer be trading at a comfort level so you have to reduce exposure.

John Nyaradi: Jack, everyone knows you’re a bestselling writer but you’re also co-portfolio manager for the ADM Investor Services Diversified Strategies Fund, a portfolio of futures and FX managed accounts. Tell us about that.

Jack Schwager: The fund is structured with only managed accounts. So it avoids the problems of lack of transparency and lack of investor control that are inherent in typical fund structures. Also ADM Investor Services has final control of the individual accounts. Managers only have limited power of attorney so they only trade their accounts.

The fund’s primary strategy is to be extraordinarily diversified in liquid trading approaches. We only allocate to managers who are trading futures, FX, and options on markets that are exchange traded or exchange cleared. So the prices are there at every moment, and any of these accounts can be liquidated in a fraction of a day, let alone a day. As a result, the portfolio is much more liquid than what you get in a typical hedge fund structure. As for the managers, we look for people who have good return to risk and are doing something different than everyone else in the portfolio. We have a completely diverse group of strategies, and the correlation among the different managers is very close to zero, which is what we designed the fund to do.

John Nyaradi: Jack, we are talking here in early summer 2012, and I always like to end these conversations with an open ended question about what you see ahead for the market, what retail investors should be watching out for, what keeps you up at night?

Jack Schwager: Well, nothing keeps me up at night [laughing], but if anything were, in terms of concerns, it would be the dysfunctional state of the US political system coupled with the looming danger of the growing deficit problem.

It’s not something that can’t be solved. It can still be solved, but the longer it gets delayed, the worse it gets. People say we can’t be Greece. Well, if Congress doesn’t change over the next 5-10 years, we could be Greece. I want to be clear here that I am equally critical of both parties. I think they are both totally guilty of placing political expediency ahead of the good of the country. If the measure is action rather than talk, I don’t think either party has demonstrated courage in making difficult decisions or being honest with the American public. My heroes are Simpson and Bowles (one Republican and one Democrat), but they are not in office, are they?

As far as the market goes, a lot is going to depend, on how the European situation plays out. There is a reasonable possibility that you will get further extreme problems in Europe, which will have a domino effect. Then you also have the US, which has its own problems since we’re not really out of the difficult economic throes by any means. You also have a potential sharp pullback in spending and tax increases that might hit at one time at the end of the year if Congress does nothing.

So having those things looming may also frighten the market. If we do have a decline like 2008 or anything close to it, I would be looking at that not as a time to get scared but rather a time to take a commitment in the market because such a decline will take you down to price levels that are very low relative to the earning power of companies. Also, with interest rates at extremely low levels, bonds are an unattractive long-term investment with a real possibility for negative capital gains over the long term if bonds are bought after another market sell-off when rates will likely be even lower.

All of those factors would argue for taking a long position in equities, domestic and international, if the situation got ugly. So what I would say is that investors should be on the lookout for that possibility, and if it happens, not be overly frightened by a panic sell-off because those situations tend to be the best opportunities to get into the market.

John Nyaradi: Well, folks, we’ve been talking with Jack Schwager, a recognized industry expert on futures markets and hedge funds. He has written some classic books, “The Market Wizards,” “The New Market Wizards” and now his latest is “Hedge Fund Market Wizards” that I’m sure will become a classic, as well.

You can learn more about Jack and his book by clicking on the link at the end of this interview.

Jack, thanks for joining us. I learned a lot and I know we’re all looking forward to talking with you again soon.

Learn More About “Hedge Fund Market Wizards”

(Recorded conversation, edited for length and clarity)