Fung, Ko, & Yau, Dim Sum Bonds

Let’s start with a definition. Dim sum bonds are, as the subtitle says, “the offshore renminbi (RMB)-denominated bonds.” Since 2007 they have been issued in Hong Kong and, as such, are available to investors worldwide. Dim Sum Bonds, coauthored by Hung-Gay Fung, Glenn Ko, and Jot Yau (Wiley, 2014), offers a “panoramic view of [this] bond market that has played a pivotal role in China’s grand scheme of making the RMB a global reserve currency.” (p. xii) The offshore RMB market also serves two other major goals of the Chinese government: to “control smooth cross-border capital flows to China so as to harness the inflation in mainland China” and to tap foreign capital. (p. 4)

The RMB bond market serves not only the Chinese government and Chinese financial institutions. Foreign firms operating in China who need RMB funding “can raise longer maturity RMB funding through the dim sum bond market instead of relying on shorter-term borrowings from Chinese banks.” (p. 18) The first foreign company to take advantage of the RMB bond market was McDonald’s; since then Caterpillar, Ford, Unilever, BSH Bosch, and Siemens have also issued bonds. Foreign corporations account for 6.15% of the total number of issues and 8.84% of the total RMB amount. They are, as one might suspect, dwarfed by banks (predominantly Chinese), which make up just over 50% of the total RMB amount.

Who invests in the nascent dim sum bond market? The major holders are investors based in Asia, but the authors predict that interest in this market will become more global. It’s too early to say whether dim sum bonds can be considered an asset class and whether they play an efficient diversification role in portfolios. Between 2011 and 2013 the Bank of China (Hong Kong) Dim Sum Bond Index showed relatively low or, in a few cases, negative correlations with other assets such as the JPM Global Aggregate Bond Index and Barclays U.S. Aggregate Bond Index, the Nikkei 225 in equities, and the Japanese yen, Brazilian real, and British pound sterling in exchange rates.

Even though individual investors are unlikely to buy dim sum bonds in the near future, this book is still worth reading. It sheds light on Chinese currency issues as well as on Asian investor sentiment. And it is vital for anyone who wants to know more about the offshore RMB bond market.

Horan, Johnson, & Robinson, Strategic Value Investing

The three authors of Strategic Value Investing: Practical Techniques of Leading Value Investors (McGraw-Hill, 2014)—Stephen M. Horan, Robert R. Johnson, and Thomas R. Robinson—are all Ph.D.s with ties to the CFA Institute. Their credentials shine through in this cogent, comprehensive book.

The authors advocate strategic value investing, where by “strategic” they mean “being thoughtful about the characteristics of a particular security rather than blindly applying some sort of trading or classification rule.” (p. 21) There are no magic formulas to successful strategic value investing. Each investor has to find his own style, do his own leg work, and remain patient and disciplined.

The book is divided into three sections—introduction, measuring value, and value investing styles and applications. In the section on measuring value the authors discuss concepts of value, dividend discount models, free cash flow models, asset-based approaches, residual income models, and relative valuation. The most interesting section, at least for someone with a grasp of the principles of value investing, is the third. There the authors address value investing styles, choosing the right style and valuation model, distressed investing, and applying value investing to the market.

They introduce the chapter on value investing styles with an apt quotation from Christopher H. Browne: “Value stocks are about as exciting as watching grass grow. But have you ever noticed how much your grass grows in a week?” (p. 227) Here they examine the styles of nine noted value investors—Benjamin Graham, Warren Buffett, Seth Klarman, Bill Ruane, John Neff, Tweedy Browne Company, Wally Weitz, Charles Brandes, and Bill Miller. Bill Miller is presented as a “cautionary tale”: “Confidence is a positive quality in an investment manager. On the other hand, overconfidence can be lethal. Value investors often see falling prices as buying opportunities. If you like the stock at $30 per share, then you should love it at $20 per share. Miller underestimated the depth of the financial crisis and kept purchasing shares of financial stocks as prices continued to weaken. This overconfidence was exemplified by his remark that ‘the only way he would stop buying more when a stock’s price fell was when we can no longer get a quote.’” (p. 243)

Although, over time, value stocks outperform growth stocks and small stocks outperform large stocks, the authors point out one major downside to value investing—that “value stocks tend to have greater variability in returns than growth stocks, and small stocks have greater variability in returns than large stocks.” (p. 250) Value investors therefore have to decide how much volatility they can tolerate in their portfolio at every stage of their investing career.

Halsey, Trading the Measured Move

David Halsey throws out the old notion of a measured move: that you copy an AB move up (or down) and paste it on a retracement low (or high) of C to get your price target D. In Trading the Measured Move: A Path to Trading Success in a World of Algos and High Frequency Trading (Wiley, 2014) he substitutes Fibonacci levels.

He uses three trade setups: the traditional 50% retracement measured move (MM), the extension 50% MM, and the 61.8% failure. When a trade is entered, its target is 123% from a swing high or low (and sometimes from a breakout) that is followed by a retracement (50% in the traditional setup). That is, the target is AB + 23%. Halsey shows both successful and failed MM trades on charts—unfortunately usually grey bars on a black background, which makes them hard to decipher.

The measured move trade setups are not stand-alones. Halsey discusses the use of multiple time frames, seasonality, NYSE tools, tick extremes and divergences, and gaps. He also discusses how to manage positions and take profits, advanced (actually, pretty basic) risk management, trading psychology, and having a trading plan and journal.

The virtue of this book is that it touches on almost everything a short-term trader needs to consider when devising a trading plan. Some things will eventually be discarded, others will be tweaked. And even though Fibonacci levels are not necessarily the best ways to organize price data, they do bring some order, real or imaginary, to price fluctuations.

Trading the Measured Move can be supplemented with educational videos on the author’s website, eminiaddict.com, although much of the material there is for members only.

Roose, Young Money

You’re a college student with a yen to go to Wall Street and become a master of the universe. Well, you might want to rethink your dream. In Young Money: Inside the Hidden World of Wall Street’s Post-Crash Recruits (forthcoming, Grand Central Publishing, 2014) Kevin Roose profiles eight of the seemingly lucky ones. Most of them got two-year contracts as analysts in the investment banking divisions of major Wall Street firms. Although they knew the work would be demanding, they started off full of excitement and determination. Soon enough reality set in.

The problem wasn’t simply the long hours first-year analysts are expected to put in. It was the lack of control of the hours. “At-will scheduling is the bane of the young analyst’s existence. It means that every evening activity is subject to last-minute cancellations, that stress-free vacations and personal trips out of town are impossible, and that work-issued phones function as permanent third limbs.” (p. 40) Why the hundred-plus hour weeks of on-call work? They are, people told Roose, “one half of a grand, unspoken social contract that had existed on Wall Street for decades. As part of the basic bargain, analysts were asked to demonstrate full loyalty to the firm by becoming a slave to its demands. In order to fully belong, the first-year analyst had to realign his priorities, replacing his own with his bank’s. And seen in this light, all the young banker’s cancelled dinners and broken relationships aren’t just unpleasant externalities—they were central to the process.” (p. 107)*

Another problem the young recruits faced was that “Wall Street … makes its workers feel expendable; many entry-level bankers conceive of themselves as lumps of flesh who perform uncreative and menial work. “ (p. 43) They are nothing like those senior investment bankers described in the 1976 book The Financiers who have lavish offices and dress in expensive suits and who are the “richest wage earners in the world.” Today the offices of the young bank analysts “are covered in moldy takeout containers and pit-stained undershirts. They dress in whatever is left in the clean laundry bag from last week, and haven’t seen sunlight in two months. They make pitch books for clients who will never read them, and get yelled at for improperly aligning cells in Excel, all in hopes of a year-end bonus number that won’t make them want to jump in front of the 4 train. They are the young investment bankers of Wall Street, and they just want some sleep.” (pp. 43-44)

Some of these young analysts became almost morbidly depressed. One coped with the help of a countdown clock which he set for 336 days—the amount of time between the day that his equally miserable Goldman friend gave him the clock and when he estimated the following year’s bonuses would be paid. Although he might not be able to handle an entire career at Goldman, he figured he could make it through 336 days.

In some cases the unhappy analysts plotted their escape to ostensibly greener pastures, like Silicon Valley. In other cases they failed to make the grade and got their walking papers after their two-year stint. Still others decided to tough it out and remain in finance. In fact, according to one headhunter, “only 10 percent of young Wall Street workers ever leave to work in a completely different industry.” (p. 225)

Roose’s book focuses on the toll that Wall Street took on these young financiers. Over the three years that he tracked them, they changed in troubling ways. “I’d seen most of them become less happy and optimistic, more cynical and calculating. They were slower to smile and quicker to criticize. Many of them began to talk about the world in a transactional, economized way. Their worlds started to look like giant balance sheets, their appetite for adventure waned, and they viewed unfamiliar situations through the cautious lens of cost/benefit analysis. … There is, in other words, an enormous cost associated with our nation’s long-standing practice of sending huge numbers of our most promising college graduates into finance. These financiers form an elite class that will go on to become influential in the top ranks of government, technology, and culture. And if they all share the experience of having spent their formative years working as entry-level bank analysts, performing and internalizing the ethos of the financial sector, it means that, in a way, we’ve allowed Wall Street’s culture to enter our national bloodstream. It’s the consequences of that cultural contagion—and the genuine misery I saw Wall Street inflict on so many young people—that makes me glad that the financial sector is smaller and less dominant now than it was before the crisis.” (p. 234)


*James Surowiecki, in his January 27 “financial page” for The New Yorker, addresses the changing cult of overwork. He writes: “Grinding out hundred-hour weeks for years helps bankers think of themselves as tougher and more dedicated than everyone else. And working fifteen hours a day doesn’t just demonstrate your commitment to a company; it also reinforces that commitment. Over time, the simple fact that you work so much becomes proof that the job is worthwhile, and being in the office day and night becomes a kind of permanent initiation ritual. The challenge for Wall Street is: can it still get bankers to run with the pack if it stops treating them like dogs?”

Drobny, The Invisible Hands

In his preface to the new edition of The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money (Wiley, 2014) Steven Drobny contends that “real money investors remain stuck in their antiquated ways. They will view their investments from a notional allocation standpoint, and diversify their holdings by asset class names, not by underlying risk characteristics.” Investors are unprepared for another crisis, despite the fact that “quantitative easing is coming to an end, and tremendous uncertainty exists everywhere.” Hence the renewed timeliness of the interviews, conducted in the spring of 2009, with traders who managed to navigate the financial crisis of 2008.

With the exception of Jim Leitner, who was also interviewed for Drobny’s Inside the House of Money, the managers—ten who run global macro hedge funds and one real money manager—remain anonymous. Drobny “chose the anonymous route to increase candor as well as keep the focus on the ideas as opposed to the personalities.” (p. xxx)

The Invisible Hands is a terrific book even though many of the strategies described in it are difficult if not impossible for the individual investor to implement. But the thinking behind these strategies and the way their risk is managed are often so compelling that everyone who is active in the markets can learn a tremendous amount from the interviews. Moreover, even though most of the contributors are anonymous their life stories are fascinating, sometimes even inspiring.

Here are just three snippets. They are not representative of the book as a whole because it doesn’t lend itself to such piecemeal extraction.

“The Philosopher” finds opportunities in our flawed attempts to understand an uncertain economic future. “The human brain,” he notes, “is not wired to understand probability very well. We are particularly bad at understanding low probability events, which we tend to think of as either inevitable or impossible. Therefore, a very small change in the underlying fundamental probability can sometimes cause wild swings in sentiment because the potential outcome went from impossible to inevitable, whereas the underlying fundamentals did not move substantially. Shifts in sentiment cause markets to move much more frequently and violently than shifts in fundamentals do.” (pp. 98-99)

“The Predator” always wants to know what kinds of people are on the other side of his trades. “You need buyers to short against at the top of the market and sellers to buy from at the bottom. You have to identify the type of person who shorts at the bottom or the one who leverages on the way up and use the liquidity they provide to do your trades. You need to understand where other people get it wrong in order to see if their errors create an opportunity for you.” (p. 315)

And, finally, “The Plasticine Macro Trader” opines that “even a true contrarian is only really contrarian about 20 percent of the time; it’s all about choosing the right moment to fight convention. The rest of the time is spent trend following.” (p. 344)

Bhansali, Tail Risk Hedging

Vineer Bhansali’s Tail Risk Hedging: Creating Robust Portfolios for Volatile Markets (McGraw-Hill, 2014) is a book that unfortunately will never reach a mass audience. I say “unfortunately” because by and large investors are horrible risk managers. Most have long-only portfolios; the savvier among them pride themselves on being diversified. But in a major sell-off, where correlations usually increase dramatically, they are unprotected and will most likely end up bloodied.

Bhansali argues that “typical investment portfolios … suffer from too much asset-class diversification and not enough risk diversification.” (p. 184) The problem is that “even assets that are fundamentally uncorrelated may become correlated on the tails if they are affected by a common liquidity factor.” (p. 18) This problem, however, can be converted into an opportunity. “For example, if we believe that there are concentrated carry positions in some currency pairs that will come under liquidation pressure if the equity or credit markets come under pressure, then a carry currency put option bought in advance of the stress would prove to be a cheap way of hedging.” (p. 19)

Bhansali emphasizes that “the use of market-traded options is a simplification that works only if the underlying hedge objective is rather plain vanilla. If the objective is more complex, for example, ‘hedge so that at no point in time does the portfolio suffer a loss of more than x percent,’ the reference index security would have to be more of an exotic option such as a knock-in option.” (p. 41)

Options are not the only way to hedge tail risk. “We should use cash, diversification, alternatives, and explicit hedging within a consistent cost-benefit tradeoff to construct the most efficient and practical solutions.” (p. 43)

Bhansali explores the advantages of static hedges versus dynamic hedges. “In static hedging, the buyer of protection buys a contractual obligation that if a particular event were to happen, the seller of the protection would pay according to a predefined formula. By contrast, in dynamic hedging, the protection seeker uses some algorithm to create the payoff he would have as if he had actually purchased the static hedge but without actually paying for the hedge now. In other words, static hedging is outsourcing of risk management to the options, whereas dynamic hedging is doing option replication in-house. In practical terms, static hedging consists of buying options, for example, S&P500 put options or indirect options, whereas dynamic hedging is done by replicating the option using the underlying instruments, for example, by selling and buying S&P500 futures.” (pp. 146-47) Bhansali suggests that the investor should “pay as you go for small losses using rebalancing and dynamic hedging, but … combine this strategy with sufficient static hedges on the tails to avoid the possibility of permanent losses from the rare but severe fat tails.” (p. 152)

When trying to hedge tail risk for retirement accounts, the investor is confronted with “the interplay among risk aversion, horizon, and the dynamics of markets over long periods of time.” The author says that everything he has written about tail hedging for asset allocation “still holds true, such as the need for active management, its role as an offensive risk-management tool, and its role in mitigating downside risks. However, the introduction of time to retirement and risk tolerance as new variables makes the exercise even more complex and fruitful.” (p. 186)

Although Bhansali oversees PIMCO’s quantitative investment portfolios, he introduces relatively little math in this book. The reader should, however, be familiar with options and the basic metrics of risk management.

Drobny, Inside the House of Money

If you haven’t read Steven Drobny’s Inside the House of Money: Top Hedge Fund Traders on Profiting in the Global Markets, newly revised and updated (Wiley, 2014) you should immediately add it to your “to do” list. It doesn’t matter whether you’re a global macro trader or not. I’m not, and yet it’s one of the very few books I keep returning to and learning from.

Originally published in 2006, the book is a collection of twelve interviews with top global macro practitioners. Although times have changed—the interviews were conducted before the financial meltdown and since then global macro has gone mainstream—the book remains a font of trading wisdom.

Few of the interviewees are household names; notable exceptions are Jim Rogers and Peter Thiel, and Thiel has since closed down his fund. The other named traders (one is anonymous) are Jim Leitner, Christian Siva-Jothy, John Porter, Sushil Wadhwani, Yra Harris, Dwight Anderson, Scott Bessent, Marko Dimitrijevic, and David Gorton and Rob Standing.

It’s, of course, impossible to summarize this book, which is one reason it’s so valuable. But, just to give a bit of its flavor, here are a couple of excerpts.

First, from Scott Bessent, at the time of the interview running his own fund but now the chief investment officer of Soros Fund Management. He said that his fund uses technical analysis as a way to see what the crowd is thinking. “And we also use it to keep us on top of things we might not be seeing. We have a system that screens about 1,400 stocks and commodities around the world every week. We never trade based on it, but if all of a sudden 10 stocks in Indonesia show up, then we’ll look at Indonesia.” In response to a question about the source of his information, he said: “A lot of newsletters, thought pieces, magazines. We get very few ideas talking. We basically just sit around here and read.” (p. 271)

Second, from the thought provoking interview with Jim Leitner of Falcon Management. His fund—at least at the time of the interview—allocated 10 percent of its NAV to a baseline portfolio, which dynamically adjusts the weights on how much money it holds in equities, fixed income, commodities, currencies, and real estate, based on a momentum following model. It is a model “with no forecasting, no thinking, and no work to implement. We rebalance the model book every Thursday and do not do anything in between.” The fund’s overall performance the previous year was 29% as opposed to the 14% return of the baseline model, but, Leitner said, “the baseline model keeps me sharp. I know that there is always someone out there who is trying to each my lunch.” (p. 77)