I Know EXACTLY How Your Index Fund Will Crash

Boris Schlossberg

Ah, the glory days of passive investing. Has there ever been a time when it paid so handsomely to be dumb money? While Wall Street Masters of the Universe close up shop and day traders fight to the death for every single basis point, Mom and Pop investors continue to grow rich with every passing day by blindly buying their Vanguard funds on a regular basis.

Hell, even Hedge Funds have stopped fighting the trend and joined the party. Business Insider recently reported that “Hedge funds are crushing it with a trade that anyone can replicate” noting that the best and the smartest are now basically buying up the emerging market ETFs (EEM, VWO) owing more than 12.4% of all outstanding shares.

It’s easy to believe that easy money will continue to flow. After all, the single decision bet of buying a cheap well-diversified ETF has been the most profitable investment idea of the past decade. No worries about risk control, commission costs or even selection bias. It’s done for you. Just set it and forget it as Ron Popeil used to say.

But mark my words this will end very badly for most investors and I know exactly how.

This week FT reported about the “Tech Tantrum” last Friday when many of the best known and biggest companies suddenly tumbled without a reason. What happened? As FT explains, an increasing number of institutional investors now use “factors” to allocate their money. Factors such as “growth” or “value” are the basic building blocks of market performance, and investors can try to cheaply and passively beat their benchmarks by tilting towards some that have shown to produce benchmark-beating returns over time.

“Indeed, the correlation of the “FAAMG” stocks – Facebook, Apple, Amazon, Microsoft and Google – to the growth, volatility and momentum factors are in the 92nd, 90th and 96th percentile respectively, Goldman Sachs noted on Friday. Tech has this year been even less volatile than utilities.

When tech began to buckle, reversing both their momentum and low-volatility factors, systematic funds would begin to sell, with nervous traditional mutual and hedge funds – which have piled into the sector this year – adding to the pressures.”

If all of this sounds familiar then you must be old, because I have only one word for you -- 1987.

Yes if you are old enough to remember 1987 then you know how 25% of your whole net worth can be wiped out in a single market afternoon. At that time, the new fangled “program trading” system managed to create the biggest crash in market history.

Robots have no feelings and at a time when only 10% of all trades are proprietary, the soothing, vol dampening aspect of algorithmic trading which has created so much complacency in the market over the past 8 years can quickly morph into a death-defying momentum crush of the machines.

Almost no one believes that US equities could fall by 50% in one day which is precisely why it can and will happen. Because machines have no limits and will pound an asset down to zero if the algo rules suggest that to be the highest probability in the next hour.

So active traders, don’t despair. Your hard work and knowledge of risk control may protect you yet because in life passive never pays in the end.

Three Things I learned from a Superstar Hedge Fund Trader

Boris Schlossberg

Last night I hosted a webinar with Turney Duff, the New York Times bestselling author of The Buyside and former trader for Galleon, Argus and Jim Cramer’s old hedge fund. Turney is a natural raconteur and he told many wild stories of the gogo 90’s and 00’s in hedge fund business when young men and women of Wall Street felt like they owned the world.

Turney had access to the very center of power on Wall Street and was witness to all of the insider games that went on in the markets. But last nights conversation did not dwell on the women-drugs-money excess of the era. Instead we talked shop for an hour and a half and his insights into what makes a successful trader were fascinating. So I thought this week and next I’d share his ideas with you.

1. There is NO ONE STRATEGY for success.

One of Turney greatest skills is his ability to improvise and adapt. His greatly appreciates the fact that financial markets are always changing. In fact change is the only constant in the markets. Markets change not only in style (going from trending to choppy and vice versa) but in structure as well (from human voice trading, to computerized entry, to robot to robot trading). He readily conceded that some of his fast news trades would now not work in a market when robots beat you to the punch. So to be successful today, a trader needs to have a longer horizon and compete on analysis rather speed.

2. Never let your Profit and Loss Statement Determine Your Trading

This is such a common mistake that many of us are not even aware that we are making it. How often do you find yourself selling your position just because its profitable and “you made enough” or holding on to a loser “until it gets back to even”. By doing this we let the account equity drive our entry and exit orders. The end result is that all of us wind up cutting our winners short and letting the loser bleed. Indeed every study of retail trading accounts shows this pattern repeats over and over. According to Turney, the only question you need to ask yourself is “IS THIS POSITION A BUY OR A SELL RIGHT NOW?” If you did not have this trade on -- what would you do? If the answer is opposite of what you are doing then make the change.

3. You are not trading stocks, you are not trading currencies, you are not trading options -- you are trading INFORMATION

When you are speculating you are engaged in the art of trading information. We tend to objectify our trades and because as human beings we need to relate to something concrete we will often find ourselves attached to a position because we “believe” in the particular stock or currency pair. In reality they are just abstract symbols. It is very important to realize that when we trade we are simply speculating about the value of the information to the marketplace. That’s all. If the information isn’t valuable, our trade won’t work. That is why it is not worth it to obsesses or get emotional about any specific trading idea in your account. Its just a bet on information and no matter how much you cheer or curse it -- it really doesn’t care. The trade will do what the trade will do.

Next week I discuss why Turney thinks you should cheer and celebrate all your losses and how anyone can find strong trading ideas without resorting to insider info.

The video of the webinar can be found here