Five Key Lessons from Hedge Fund Market Wizards

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Nov 12, 2024

Two years ago, we introduced readers to a post titled ‘Value Investing Revisited’. Today, we’re excited to continue exploring similar themes. For those wondering about the name Value Punks, it was initially a playful nod to the NFT craze, specifically the CryptoPunks series. But it also reflects our investing ethos. Unlike traditional value investors, we embrace unconventional strategies. We don’t confine ourselves to established frameworks; instead, we challenge the status quo and carve our own path. We hope you enjoy this follow-up post and continue with us on our journey to redefine value investing.

Jack D. Schwager’s Market Wizards series holds near-canonical status among investment aficionados. Most literature on equity investing dives into the “what” and “why” of mispriced stocks, but far fewer texts tackle the “when” and “how” with comparable rigour and authority. Hedge Fund Market Wizards stands out for addressing both, sharing real-world insights on timing and process from some of the best in the business.

The book traces common threads of wisdom while spotlighting divergent strategies, underscoring a central lesson: the best approach is one that fits your own temperament and strengths.

The five lessons that follow—better described as “insights”—were chosen for their practical, thought-provoking nature. Rarely discussed in value investing circles, these perspectives aren’t necessarily endorsements but are well worth considering. Some quotes have been lightly edited for clarity.

1. Steering Clear of the “Pigeon-and-Elephant” Trap

Schwager credits Martin Taylor with “possibly the best performance record in emerging markets.” Between 1995 and 2011, Taylor achieved a compounded net return exceeding 27% annually, comfortably more than double the 12% return of the emerging markets index. After his firm’s AUM swelled to over $7 billion and its NAV neared an all-time high, Taylor took the unusual step of cutting assets by over 75%, prioritizing well-being over maximizing earnings. In an industry focused on scaling AUM, Schwager calls this move “a rarity, if not a singular event.”

Taylor’s strategy mirrors many fundamental equity managers but with two notable twists: he closely monitors macroeconomic conditions, even making his own forecasts, and he steers clear of “boring” companies—usually low-beta stocks—even if they seem attractively valued. As he puts it:

“Buying low-beta stocks is a common mistake investors make. Why would you ever want to own boring stocks? If the market falls 40% for macro reasons, they fall 20%. Wouldn’t you rather just hold cash? And if the market rises 50%, the boring stocks go up only 25%. You get negative asymmetric returns. It’s what I call a pigeon-and-elephant trade—you eat like a pigeon and shit like an elephant. To get equity-like returns from a portfolio of boring stocks, you have to leverage it up. If things go wrong, the loss will be massively asymmetric due to the leverage.”

Taylor’s approach is not for the faint-hearted, and he cautions against it if investors or their clients cannot tolerate significant monthly drawdowns.

This high-wire approach contrasts sharply with that of BlueCrest’s Michael Platt, another Market Wizard known for his deep aversion to losses, which kept his fund’s largest drawdown below 5% over 11 years preceding the book’s publication. Platt explains, “I don’t have any tolerance for trading losses. I hate losing money more than anything. Losing money is what kills you. It’s not the loss itself but the fact that it messes with your psychology. Then the elephant walks past while your gun’s not loaded.”

2. The Art of Admitting Errors

Reflecting on traders who faltered at his firm, Platt observed, “They blew up because they became too attached to their positions. Ego got in the way. They just didn’t want to be wrong, and they stayed in their positions.” In contrast, he says, “When I’m wrong, my only instinct is to get out. If I thought one way but now see it was a mistake, I’m probably not the only person in shock, so I better be the first to sell.”

This demand for mental flexibility may sound obvious, yet it was frequently cited throughout the book as the defining trait of successful investors—suggesting it is rarely observed in practice. Human nature inclines us to ignore, rather than seek out, information that contradicts our beliefs (the classic confirmation bias).

George Soros exemplified this trait, as recounted by Colm O’Shea, a Market Wizard who once worked for him: “[Soros] has the least regret of anyone I’ve ever met. He has no emotional attachment to an idea. When a trade is wrong, he just cuts it, moves on, and does something else.”

3. Precision in Position Size and Timing

“Investors often miss the best stocks because they can’t bring themselves to buy a stock that has already gone up a lot,” notes Taylor. His solution, shared by other Market Wizards, is simple: “Suppose I’m enthusiastic about a company and want a 10% portfolio stake. If the stock is overbought, I won’t hold back from buying—but I’ll start small, perhaps 1%, since a correction is more likely. If the stock continues to rise, I’m glad to have some skin in the game and may add more at a higher price. But if I don’t buy it at all because it’s overbought, I’d probably never buy it, which would be a dreadful mistake.”

Many investors err in the opposite direction, warns Joe Vidich, another Market Wizard: “They let greed drive their position sizing beyond comfort levels. Why settle for a 5% position when you could double it to 10% and, presumably, double the profits?” However, larger positions can easily lead to decisions driven by fear rather than sound judgment.

And what of timing? Although using chart analysis to time trades is often dismissed as heresy in value-investing circles, several Market Wizards find it a valuable, even indispensable, supplementary tool. “Once I have done the fundamental work and decided to buy a stock, I will first look at the chart before putting on a position,” says Taylor. “If I’m bullish but not fully invested and the stock breaks out on the chart, I’ll go to a full position because the breakout confirms that the market is now seeing what I see.”

O’Shea observed that George Soros’s genius lay not just in knowing his position was right, but in recognizing the precise moment to act. “Knowing not only that a position was correct, but that it was right now—that the moment had come to take big risk,” he reflected. Some of O’Shea’s biggest errors came not from faulty analysis, but because no one else cared. “As long as no one cares, there’s no trade. Would you have shorted the Nasdaq in 1999? You can’t just be short because something seems overpriced. You wait until people start to care. You might want to sell Nasdaq at 4,000, but only after it hits 5,000. You sell on the way down, not up. In a bubble, who knows how high it can go? Even if an idea is sound, you have to wait for and recognize the right moment.”

4. Risk Control: Scaling Down and Setting Stops

The Market Wizards vary widely in their approaches: some let winners run and cut losers, others take partial profits or trim positions, sometimes using stop losses and sometimes not. One manager in the “let winners run” camp explains his method: if he buys a stock at $40 and estimates its fair value at $80, he’ll begin selling at $75—but only after it has surpassed $80. He argues that selling at $80 risks sacrificing more on the upside than the minor drop from selling at $75 on the way down.

But what if a position heads south? Many investors, torn between cutting a loss and holding out for a recovery, find themselves paralyzed. Vidich suggests a middle ground: “Don’t try to be 100% right.” Instead of making an all-or-nothing decision, he opts for partial liquidation, gradually trimming his position if losses mount, eventually exiting entirely if the stock fails to turn.

“Sometimes it’s best to liquidate entirely, as it forces a re-evaluation,” he says. “When you’re in the trade, you’re always defending it.” Conversely, liquidating the position lets you decide more objectively whether it would be better to buy it back or buy something else.

One frustrating but inevitable consequence of tightly controlling losses in this way is that there will be times when you exit a position just before the market turns around. Yet this disciplined approach enabled Vidich to keep his maximum drawdown to 8% over a decade and two major bear markets, while generating a remarkable 24% compounded annualized gross return.

5. Managing Exposure and Liquidity

Kevin Daly, a Market Wizard, achieved gross returns of over 800% across a 12-year period, even as equity indices largely stagnated—all while remaining predominantly net long. His secret? Stock selection, certainly, but equally crucial was his skill in knowing when not to be invested. He compares his approach to Debussy’s maxim: “Music is the space between the notes.”

Martin Taylor, meanwhile, adopts a similar strategy with a twist. “If you’re trading volatile instruments and find yourself entirely out when the market rebounds, you might never get back in,” he explains. Taylor maintains a degree of net long exposure even during bearish periods—a strategy that served him well during the wild swings of late 2008. While this partial exposure led to losses in 2008, it also positioned Taylor to benefit when the market rebounded in March 2009. Staying in the game made it easier for him to double his net long exposure to 40% as conditions improved. He believes that, had he been net short, he would likely have waited for a pullback to cover—a pullback that, of course, never came.

Final Thoughts

This article barely scratches the surface of the insights packed into Hedge Fund Market Wizards. Recently, the legendary Stanley Druckenmiller—profiled in The New Market Wizards (1992)—shared his investment philosophy and process in an interview, many elements of which echo the themes explored here.