Yesterday, I spent the evening with a good old friend, now a senior manager in a big financial firm, whom I will label as “Manager X” going forward. I believe some parts of our conversation will be interesting to everyone, my summary below 🙏🏻
1 – Why is there no alternative but to ride this market?
Manager X: “We are not competing against a benchmark anymore. That’s a thing of the past. Now, you are competing against other money managers. Playing it safe because valuations don’t make sense will automatically impact your relative performance, and your clients won’t take long to pull money out and reallocate to your competition.”
2 – How do people try to outperform each other?
M-X: “You need to be smarter in harvesting alpha from the trend. Options are particularly good for the job since 90% of the time, options expire out of the money. So, 9 times out of 10, you will be right in shorting them, and you can build leverage without borrowing money at these expensive interests. If the trend is bullish, you are better off selling puts, while if it’s bearish, you would rather sell calls.”
3 – Aren’t you afraid a sudden shock will make you lose money on your short puts?
M-X: “Not really, as said, you make money 9 times out of 10. If you pick up a 2% premium 9 times, that’s 18%, and the 10th time you don’t make money, the stock will hardly go 3-5% beyond your strike so at best you lose 1-3% net. Furthermore, that has very low chances of happening simultaneously for several positions across your portfolio.”
4 – What about a systemic shock?
M-X: “There are tiny chances of it happening for long stretches of time. If it does, everyone will be in trouble, and your client will hardly blame you for that. If you consider that you aren’t managing your own money, you have no personal downside in just riding the waves of the market”
5 – So, aren’t you afraid of a market crash?
M-X: “People know we are in a bubble, it’s undeniable, but no one knows how long it can last. Furthermore, there is still so much money sloshing around that wants to find a place, and no client is interested in buying bonds and waiting for an indefinite period of time for #stocks to go down to buy at better levels, missing potential gains in the process. You’d rather be right for years and wrong when things go wrong for everyone rather than be against the market, lose money and/or opportunities during that time, and after years say you were right.”
6 – So basically, is there no need anymore for risk management?
M-X: “Risk management is more of a factor of remaining within the boundaries of your management mandate. All you need to do is to be fully invested and deliver the highest possible Sharpe ratio unless you are #WarrenBuffet. In that case, you can do pretty much whatever you want and hold as much cash as you want without fingers being pointed at you because of that.”
7 – If everyone is chasing the same trend, then who is taking the other side of the trade?
M-X: “Let’s say I want to buy a stock, my bank doesn’t have it in its inventory, and there is not a seller out there at a decent price. All they will have to do is borrow it from somewhere else to still close the trade. Stock lending is the way asset managers without the mandate to do derivatives extract alpha. For derivatives, I doubt there is anyone taking the other side of the trade, so it all comes down to replicating it and hedging your Greeks [the risk metrics for derivatives] .”
8 – How is this going to end?
M-X: “A massive crisis down the road for sure, because, while people now can sleep at night confident that if something goes wrong, they will be bailed out, this time though, there is no lender of last resort if you think about that. #FED and Central Banks are maxed out, #China won’t borrow hard anymore as they did after the GFC. Who’s left? Nobody, but it will be a slow process until people figure this out”