A conversation with a former President and a former hedge fund manager (part one)

At a conference in New York City I was privileged to listen to one of the greatest hedge fund managers elucidate his thoughts and amused to hear one of the most controversial former presidents vent his spleen. The former President was George W. Bush and the hedge fund manager Stanley Druckenmiller, most famous for ‘breaking the Bank’ (of England) in September 1992.

Part one: Stanley Druckenmiller, former hedge fund manager

By way of introduction Druckenmiller has been managing money for 30 years and has never had a down (calendar) year despite plenty of volatility in his returns, and having been down as much as 18% ytd at various points in 1999 and 2000. Getting back to positive from -18% takes some doing, and in many years he has made 50-60%. We should be able to learn a lot from him and we did.

 Druckenmiller seems to have all the attributes for being a successful hedge fund manager. As well as being charismatic and a commanding room presence, he is clearly very bright, he can articulate a vision, he can distil information and extract the most relevant facts and while he can flip his view he seems to be able to take a medium term perspective. He is not hung up with short term noise, and spurious and crappy risk management models, and he understands that your year can be made with a handful of good trades. That’s all you really need.

Yesterday he gave us some of his insights:

-          We are in an extreme economic and policy environment and therefore the chance of policy errors leading to dislocations is high. This means potentially good opportunities for macro investors.

-          Just as Paul Volcker was a radical, with a radical new policy (monetarism) to crush inflation Ben Bernanke is equally (and oppositely) radical in that he is determined to increase inflation/banish the risk of deflation with an equally radical policy of quantitative easing (QE). Druckenmiller bet on Volcker being successful in the early 80s when ten year bond yields were 14% (but short rates were 18% implying negative carry), and it would be equally unwise to bet against Bernanke succeedingeither. So bet on inflation not deflation. Likewise Reagan and Obama are polar opposites with the former deregulating the economy and the latter re-regulating it.

-          Crises are more likely where people are not looking for them. Right now they are looking in Europe and China, and neither is likely to have a full-blown crisis this year.

-          In China total debt to GDP is 130%; in the US it is 370%; he is therefore not worried about China blowing up.

-          Europe is a banking system problem more than a sovereign problem; the end-game is likely to be 50% haircuts in Greece and 25% in Portugal and Ireland.

-          The US is not Japan because Japan took so many years to address its banking system and the capital ratios declined from eight to five, whereas in the US the banks were recapitalized early.

-          Sizing trades correctly is crucial. This is what he learned from Soros. Sometimes you are hot, sometimes you are cold. When you are hot you should size up aggressively, and vice-versa.  If you are up a good amount late in the year you should go for it; that is why he had a lot of 50-60% years and quite a few single digit years.

-          In 1992 Druckenmiller explained the short sterling trade to George Soros and he had approximately 100% of the fund in the trade (about $7bn). It was the perfect trade for the perfect storm because the UK and its housing market were sinking and Germany was straining at the least and their currencies were pegged at the wrong rate with German interest rates. Soros asked him what was he thinking having just one times the fund in the trade. He should have been much bigger in it.

-          Diversification is over-rated. In fact it is a dirty word. You should put all your eggs in one basket and monitor carefully. That means you will get big draw downs from time to time.

-          If you are going to panic, however, it is best to panic early. Modern risk management systems are very flawed and the crisis exposed many of them to be severely wanting. The best risk indication is the behavior of the p’n’l.    

-          Last year he wound down his hedge fund and will trade his family money from now more aggressively and less often.

In a nutshell what are the conclusions? A good hedge fund manager needs to be able to think and articulate a view clearly, and be able to extract the most relevant pieces of information when the ‘noise to signal ratio’ is ever on the increase.  He needs to understand policy reaction functions and be able to identify potential dislocations at an early stage. Once he has identified opportunities he needs to time his trade (being early can be as bad as being wrong sometimes), identify location (less important in the scheme of things when you are playing for discrete moves) and importantly size positions correctly. Only having the right view and missing the trade is worse than not sizing up properly a high conviction idea. He should resist the strong temptation to over-trade; or to day trade or fall into the trap of reacting and being jerked around by what is essentially noise. Don’t run with the ‘risk-on, risk-off’ herd. Just a few big trades can make your year.