Quote from Ghost of Cutten:
I am curious about a common phenomenon - pro traders, especially fund managers, suffering large drawdowns.
Some basic assumptions, if recognised by a trader, should make this almost impossible unless the trader is stupid, incompetent, or taking way more risk than he should. Here they are:
1. Whatever approach you use, at some point you will run into a market environment that is very hostile to it.
2. When this happens, a large majority of your bets will hit their max possible loss (which, hopefully, is your stop-loss point on each trade, rather than a price of $0 or $margin-call).
3. You will thus earn your max expected drawdown under these conditions.
Therefore, under no circumstances should a competent trader with proper risk control ever lose more than their maximum expected drawdown.
Yet if you look at most pro traders and fund managers, almost all of them have had max drawdowns greater than they expected. But as I have shown above, this is virtually impossible if you stick to the simple and obvious assumptions above.
The logical conclusion is that most traders don't actually stick to one or more of these assumptions. We can therefore infer that they must be making one of the following errors:
1. They do not think a hostile market environment for their approach will occur
2. They are taking risk at a level high enough that a hostile market environment will cause losses way in excess of their maximum expected drawdown
3. They simply have no risk control
I'd say most pro traders have 1 and 3 covered. Therefore, the clear conclusion is that most pro traders take way too much risk.
If they take way too much risk, then we must reduce all reported returns to compensate. For example, take someone like Dan Loeb, who was down 29% in 2008, and whose peak/valley drawdown was presumably higher than that. Let's be generous and call it 35%. It is pretty obvious that no hedge fund manager plans for a 35% drawdown by choice. I'd say that 20% is about the maximum drawdown acceptable. Loeb lost 35% (probably a bit more) at the peak. That is what actually happened, therefore his true risk was higher (since market conditions worse than 2008 can and have occurred), let's say his true risk was 40% (again, generous assumption). This means that if he had been trading at proper size, his position size, and thus his returns, would be cut in half (actually slightly more than half, due to compounding effects). I don't have his precise return numbers but I think they are in the high teens. So his true return, adjusted to a sensible risk level, is actually in the high single digits. Would you pay 2 and 20 for an 8-9% gross return? If he had traded half size from the beginning, would he have attracted any assets with a return less than half of what he actually made before 2008?
This story is replicated across literally thousands of funds, most of which have returns and records worse than Loeb's (I am not picking on him, he was just the first suitable example I saw). As an example I could give the highly rated Citadel. Their flagship fund lost 50% at the worst point in 2008. This means they were taking about 3 times as much risk as they should. Their returns were in the 30% range. Thus their true returns, at a sensible level of risk (20% max drawdown) was below 10% per annum i.e. nothing special.
A further piece of evidence is that long/short equity funds have historically averaged exposure of 35-40%. Since the worst drawdown in US equity markets is 89% (1929-32) and 99-100% worldwide, their risk from market risk alone is 30-40%, double the 20% recommended limit. One can add on top the risk of shorts going up and longs falling at the same time etc.
One can conclude from this that without taking nutty levels of risk, almost all pro traders cannot make superior returns. The way to gather assets in the pro game is to take insane levels of risk (e.g. 2-3 times what is sensible), and hope that you last long enough to gather lots of money and get lots of management fees and traders' options before a hostile market environment comes along. Pro traders are effectively unethically exploiting clients' risk-blindness, or are simply risk-blind themselves (most likely the latter).
If all traders were forced to take sensible levels of risk with other people's money, i.e. max drawdowns that the clients can actually withstand (which IMO is 20% or less), arguably only about 2-3% of currently operating hedge funds and traders would still be able to make more than 10% per annum compound.
The inescapable realisation is that almost the entire hedge fund and trading industry is based on smoke and mirrors.
