Schwager on Futures Managed Tradin g More critical praise for Managed Trading . "Managed Trading is worthwhile reading fo r anyone who is in the busines s o f money management." —Jeff Yas s Managing Director Susquehanna Investment s "Jack has written the definitive books on technical and fundamen­ tal analysis; no w he addresse s the ultimate investmen t strategy— a diversified portfolio of managers. A must­read for institutional investors, pensio n fun d trustees , an d mone y managers. " —Blair Hull Managing Principal Hull Trading "Managed Trading i s a valuabl e contributio n t o th e literatur e on managed futures. Schwage r provides a lucid examination o f performance evaluatio n procedure s an d portfoli o considera ­ tions. 1 am confident that this book will be beneficial to investors and trading professionals." —Morton S. Barat z Executive Vic e Presiden t an d CO O Allied Capital Asset Management, Inc. Schwager on Futures Series Schwager on Futures FUNDAMENTAL ANALYSIS ^ TECHNICA L ANALYSIS > MANAGE D TRADING: MYTHS & TRUTHS A STUDY GUIDE FOR FUNDAMENTAL ANALYSIS . A STUDY GUIDE FOR TECHNICAL ANALYSIS Managed Trading Myths & Truth s 1 Jack D . Schwage r John Wiley & Sons, Inc. New York • Chicheste r • Brisban e • Toront o • Singapor e With love to my son Daniel, whose solid character and sense of humor are a constant source of delight, who waited patiently, and impatiently, for this book and its two companion volumes to be completed, with a promise to make up for our time lost. Foreword My experience on Wall Street suggests that the financial world is permeated with mythology. Respecte d financial executives, who would scoff at the idea of generating profits from fortune­tellers, feel that the direction of financial This text is printed on acid­free paper. markets is , t o a grea t extent , predictable . The y ofte n offe r thei r view s o n future marke t performanc e unhesitatingly . Othe r investmen t professional s Copyright © 199 6 by Jack D. Schwager . believe that the best way to achieve high returns is through the purchas e of Published by John Wiley & Sons, Inc. undervalued assets . Beyon d thes e myths, however , ar e facts that present an entirely different picture. A s an investor or portfolio manager, yo u should All rights reserved. Published simultaneously in Canada. question thes e presumption s an d conside r approaches followe d b y som e o f Reproduction or translation of any part of this work beyond the world's great traders. I n doing so , you may gain insights that will influ­ that permitte d b y Section 10 7 o r 10 8 o f the 197 6 United ence your interpretation of events occurring in the world's evolving financial States Copyright Act without the permission of the copyright owner is unlawful. Request s for permission or further markets. information should be addressed to the Permissions Department, While almos t everyone o n Wall Stree t has a strong opinion o n markets, John Wiley & Sons, Inc. the fact is that no one can predict with consistent accuracy the future direc­ tion o f market s o r of investmen t returns. Peopl e rea d th e phrase "pas t per ­ This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. I t is sold formance i s no t necessaril y indicativ e o f futur e results " an d assum e th e with the understanding that the publisher is not engaged in opposite. Th e futur e i s no t predictable , an d I hav e ye t t o mee t anyon e o n rendering legal, accounting, or other professional services. If Wall Street or off, wit h or without a computer or doctorate, who accurately legal advice or other expert assistance is required, the services of a competent professional person should be sought. predict future events. A favorite Wall Street myth is that there are investment bargains. Peopl e Library of Congress Cataloging-in-Publication Data: are alway s lookin g t o bu y somethin g cheapl y an d sel l i t whe n i t become s Schwager, Jac k D., 1948 ­ "properly priced. " A clos e loo k a t trul y talente d trader s woul d dispe l thi s Managed trading: myths and truths/Jack D. Schwager. notion. Grea t traders know that sustained profits are made by buying some­ p. cm . Includes index. thing expensive. Whether it is the New York Yankees or Coca­Cola, buying ISBN 0­471­02057­ 5 (cloth: alk . paper ) and holding items highly valued is prudent. Whether it is their scarcity value, 1. Commodit y futures. 2 . Futures . 3 . Financia l futures. a sustainabl e competitiv e advantag e i n their market, o r extraordinary man­ 4. Foreig n exchange futures. I . Title . II . Serie s HG6046.S393 199 6 agement, there are reasons why something highly valued is likely to become 332.65'5­dc20 96­1025 6 more so over time. Another relatively new financial mythology has developed around deriva­ Printed in the United States of America tives. Derivative s were developed as a mechanism to transfer risk from those 10 987654321 vi FOREWOR D FOREWORD vi i seeking to avoid it to those seeking to proiit horn it. In today's world, though, managed futures in their investment mix have found them to be an effective it is difficul t to differentiate between those two groups of users. Whe n those and responsibl e way to enhance their risk­adjusted returns. I t is, therefore , who should be using derivatives to reduce risk seek profits and fail, often due simply prudent for a portfolio manager to undertake such a strategy. to bargain hunting, they make great headlines. The press suggests that deriv­ The compellin g cas e fo r includin g manage d future s in an investmen t atives are highly risky and that risk should be avoided at all costs. Th e view portfolio is one of the pivotal issues addressed by Managed Trading: Myths that derivatives are dangerous and speculative i s promulgated. Th e facts do & Truths. I n the exhaustively researched final chapter of this volume, Jack not support this view, however. Schwager demonstrates that managed futures can significantly improve port­ When use d properly , derivative s serv e a n importan t rol e i n th e well ­ folio performance under almost any set of reasonable assumptions. diversified investment portfolio. Managed futures is a prudent way to utilize In Managed Trading, Schwage r also explores the most important issues the benefits derivatives offer investors. Simply stated, they are a method for surrounding the use of managed futures as a viable investment vehicle. Using decreasing portfolio risk without sacrificing investment returns. When build­ much of his own quantitative research in addition to summarizing the findings ing portfolios , mos t institutional investor s fear conventionality risk—the of prior empirical studies, he seeks to provide conclusive answers to the prob­ danger that they may no t perform a s well a s thei r peer s o r a benchmark . lems all investors face when analyzing the performance of managed futures Little thought has been given to a scenario where long­term returns are flat advisors. This book is invaluable to institutional and individual investors who or negative. This is the investor's risk. The conventional view is as follows: are contemplating the use of managed futures in their portfolios, as well as If the S&P makes an inflation­adjusted return of negative 1 0 percent over a those who are already well acquainted with the benefits of such investments. decade, an d the manager experiences only a negative 7 percen t return, th e Additionally, member s o f th e manage d future s communit y will find thi s boo k manager has been successful. O f course, the manager would not have pro­ to be among the most authoritative yet written on the subject. tected the purchasin g powe r of their clients, th e investors . An d that is, i n Although you might not expect a book of this type to be controversial, its fact, thei r job. definitive approac h t o answerin g toug h question s wil l caus e a stir . Som e As we near the millennium, not only must investors contend with global readers in the managed futures community may well disagree with a number market and counterparty risks, but we may also face huge systemic problems of positions taken on the relevant issues, but with controversy comes greater due to the unrealistic, often unduly optimistic, assumptions made by the plan­ awareness o f the work that needs t o be done and, ultimately , th e progres s ners o f the world' s larges t financial institutions. Example s o f faulty or, a t that ca n b e mad e i n educatin g investor s abou t th e benefit s o f manage d worst, irrational funding assumptions may be at the core of many of our soci­ futures. Adoptin g standardized methodologies for performance analysis, eties' majo r institutions—whethe r Socia l Security , Medicare , o r th e large r including appropriate benchmarks, should be a primary goal of the industry. public an d privat e publi c pensio n fund s o f the world .