How a Fund is Developed

This is particularly true in the current markets.  We are seeing a rise in people who think they are trading geniuses and new funds launching, just as we saw in the late 1990s. In the United States, we are currently in the largest bull market in HISTORY. If you invested in almost any 100% long strategy, you likely have made money in the last ten years. (In fact, if you haven’t made money over the last ten years in a long stock strategy, quit).  A prolonged bull market like this can lead to certain strategies developing track records of five, seven, or even ten years that look quite successful – when in reality they are merely a function of a prolonged bull market. Consequently, they carry excessive risk.
 

By way of example. I had a long-term client, past retirement, that was quite well off. Our firm had him in hedged positions and conservatively invested.   In order to maintain his current lifestyle, he needed a withdrawal rate of between one and two percent per year – well below the threshold considered safe by most advisors.  He was the textbook example of a “low risk” client.  That said, his son convinced him that we, as his financial advisors, didn’t know what we were doing because his 3x to 5x leveraged FANG fund had been returning over 100% per year for several years in a row. Over my strenuous objections (even offering to help transfer his accounts to another competent advisor), he took his money and invested in a strategy that had a track record of over 7 years of returns of 25% or more every year.  The argument was “this fund returns this every year.  Why aren’t you putting money into a fund such as this?  Don’t you know what you’re doing?”  As a firm, we did everything we could to convince him that he was risking his retirement chasing returns without understanding risk.  He made the move in the second quarter of 2018.  With the vast majority of his capital.

From July 2018 to December 2018, stocks like NFLX were down over 30%. This was a problem if the fund was using 3x to 5x leverage, because the funds were bankrupted. In other words, a track record of five to seven years making amazing returns went bankrupt in a matter of a few months.  (Such a strategy could have been bankrupted in a few days at any time).  Unfortunately for this investor, his future moving forward looks quite different. 

This is because the strategy had not been back-tested and not vetted through different market conditions.  He didn’t ask the right questions, nor did he even know the questions to ask.

When a new fund is created, at least by our firm, or when we want to create a new fund or strategy the typical process is (with some variance depending on the strategy):

1. Come up with idea and mathematically test it;
    
2. Put it through extensive Monte Carlo testing;
    
3. Back test it across multiple market conditions, using actual rules (in order to have an effective back test, there MUST be firm rules followed, “judgment” calls cannot be used);
    
4. Then we try to blow the strategy up. In other words, do everything we can to develop theoretical market conditions that will destroy the strategy including assuming 100 down days in a row, having volatility plummet, and then go to an all-time high, and collapsing commodity prices. If we can find things that hurt, adjust accordingly or develop a plan for how to handle the change. We also make sure there won’t be volume issues.
    
5. Then we attempt to figure out how big of a market impact the strategy can withstand. This is done through a volume and price movement analysis. If we want to trade the market indexes, we can likely plan for hundreds of millions in trades fairly easily. If we want to trade options on VXX —- well, good luck with anything over $100,000;
    
6. We then paper trade it for ideally a minimum of six months, preferably a year; and
    
7. We put our own money into it, along with trusted individuals that understand the risk, and live trade it for, again ideally, a minimum of six months, preferably a year.

If, during paper trading and live trading, we have had different market environments, we develop higher confidence. If we haven’t had market swings, volatility swings, rapid moves down, slow moves down, rapid moves up, slow moves up, etc., we have less confidence in the strategy and will need to make appropriate risk disclosures.
 

That said, if it is a prolonged bull market, it is not rational to wait until the strategy has actually had live experience in all market conditions. If that was the case, advisors might have had to wait for over a decade before starting. Not good for business.
 

But that does mean those advisors need to EMPHASIZE these risks to investors, and they should have a multi-pronged strategy on what to do when things don’t go as expected. Potential investors should ask about the plan for how to handle different market conditions.  This is particularly true if the strategy has not been through a variety of conditions. 
 

Even then, I don’t care how much advisors have tested, back tested, thought about, and modeled, when market conditions change, advisors and investors alike are likely to be surprised by the results. Maybe in a good way, maybe in a bad way. Investors should always be warned about what the maximum theoretical loss is when trades are live. (For a 100% long portfolio, even with stop losses in place, the maximum theoretical loss is always 100%).  Discussions should be had under what conditions those max losses could occur.  An advisor should be able to give an opinion on how likely they are (with appropriate caveats).
 

Once the above is done, advisors should write it all up in a format acceptable to investors. Risks should be emphasized and discussed, not hidden.  To many funds attempt to hide risks instead of disclosing them.
 

When looking to invest in a fund, always ask questions.  Always be sure you understand the risk.  And no matter what, never, over allocate to one fund or strategy. 
 

Christopher B. Welsh is a SteadyOptions contributor. He is a licensed investment advisor in the State of Texas and is the president of a small investment firm, Lorintine Capital, LP which is a general partner of two separate private funds. He offers investment advice to his clients, both in the law practice and outside of it. Chris is an active litigator and assists his clients with all aspects of their business, from start-up through closing. Chris is managing the Anchor Trades portfolio.