A few years back I got into a conversation with one of our clients who had had just wrapped up a successful career in corporate law and was using his knowledge to start his own hedge fund.
Starting a hedge fund is not easy. Beyond the fact that you need to have strategies that constantly create alpha, you also need to go through the process of understanding federal and state security laws, hire a Prime Broker, hire the correct accounting and law firms, and then having the infrastructure in place to begin raising money.
Raising money is the heart that pumps all funds whether they are hedge funds or mutual funds. Doing double digit returns is nice. Having a few billion dollars locked up for 5 years charging a 2% management fees plus taking 20% incentive fees is better. Therefore, one is usually spending the majority of their time convincing others that they can grow their money better than other professionals.
From the outside it looks fairly simple; in reality it is harder than it looks.
Once this gentleman got everything in place he decided that he would rent space within the confines of a large established hedge fund. There, they would take care of many of his day-to-day needs and he would be around other fund managers that this firm housed. What he also got to do is see how some of the best fund managers traded the markets each day.
After being there a few months (and putting in some very good returns) he called me and told me what he observed. He told me there were dozens of different funds there and some had been in business well over a decade. Some managers traded stocks, some traded bonds, some used fundamental analysis, and some simply traded throughout the day. But the only single thing the majority of them had in common was that they “scaled-in to positions”. When they had conviction in a position, no matter what their style was, they bought more as price dropped.
As you likely know, in most books this is taught as a recipe for disaster. Isn’t it taught never to buy more lower? Yes, it is. And who teaches this? Not the best hedge fund managers in the world. These people buy lower, and if given the opportunity, they buy even lower (I remember one 30-year veteran of the industry telling me to buy a stock he liked, and to go home and hope it drops so I could buy more at an even lower price…this man helped create wealth for some of the most successful people in the country for three decades using this exact approach).
Before we go too far with this, we want to make sure that at least for us there is a structured scaling-in process in place. And we want to Quantify, Quantify, Quantify. Because whereas many of these managers have competitive advantages in understanding their asset classes or the industries they trade, our competitive advantage is being able to quantify short-term market behavior.
Over the next few days I’ll teach you the different ways to scale-in to positions. And we’ll look at the pluses and the minuses of each type of scaling-in approach. By Friday, you will have a good understanding of why so many top professionals successfully use this approach in their trading and investing.
Larry Connors is CEO and Founder of TradingMarkets.com and Connors Research.