Friday, September 11, 2009

Can a trader be a do-gooder?

It occurs to me that the only way in which a trader can become more than a completely selfish, self-enriching, narcissistic person is to trade well enough so that you can manage other people's money and thus saving these investors from crooks and charlatans (provided you are convinced you are not a crook and charlatan yourself).

Other traders have advanced other arguments in favor of trading. But I am not convinced by them.

They say that we provide liquidity to other long-term investors who may need to liquidate their investments. But then, this applies only to mean-reversal strategies. Momentum strategies take away liquidity from the market, and in some cases exacerbating price bubbles. Certainly not something your grandma would approve.

Others argue that momentum strategies help disseminate information about companies through quick price movements. But can't we just watch Bloomberg or CNBC? Do we really need some devious insiders to convey that information to the rest of us through price movements?

No, I think that independent trading should serve only one purpose (besides short-term self-sustenance): as training and preparation to become a fund manager. Once you graduated from independent trading, you then enter into the grand contest among all fund managers to see who can best serve and protect investors' assets, (and be rewarded according to your standing in this contest.)

I know, this is the idealistic way to look at things. Serving and protecting seem to be what policemen should be doing, not traders. But as in quantitative trading, I think it helps one becomes more successful in one's activities by having a simple guiding principle or model. And it doesn't hurt that in this case, the principle would also be conscience-nourishing!

17 comments:

bwc2000 said...

I couldn't agree with this post more as that is one of my goal, which is still a long way. I'm quite sure that's what in a lot of traders mind too after they become successful, as they can get more money to use as leverage.

But I think what really is consider a do-gooder is the compensation rate that the trader (now fund manager) creates for the fund that they open/create.

I believe that if they are that good, they will only be compensated based on ABSOLUTE performance. They will not need the 2% or 3% 'management fee' and they will not need say 'beat the general S&P market' to say they are good (which is relative performance)

So if they are able to generate at least 15% return, they will get say 25% of that 15% return. If they generate zero or negative return, they purely get nothing.. since they did not perform. After all, the point is the help other investors to generate returns when those investors are not as good as the trader who opened up the fund. (Why else do I need to give money to someone who will do just as good as say 50% of the population?)

I am not in the hedge fund industry so I do not really know first hand what that 2 or 3% manangement fee is or how necessary is, so feel free to differ on this issue. But from the perspective is that if the trader is that good, they can generate absolute positive return consistently and therefore can even charge a higher percentage compensate rate that normal. No need to have that 'backup' 2% management fee.

So in summary, compensation based on ABSOLUTE performance is what will be a do-good fund by a do-good trader.

Andrew S said...

I agree that one way for traders to "do good" is to manage money, and provide an investment alternative and protect others from unscrupulous investment advisors.

However, to say that all traders should aspire to be money managers is irresponsible, as you have not mentioned the limiting factors:

1) The peter principle, paraphrased as "a person will rise to their level of incompetence" - and I suspect the level of "Fund Manager" will be that level.

2) Scale. Some traders will be successful with smaller amounts of capital or only with specific assets.

It is the duty of a good citizen to vote, and it is the duty of a good trader to trade.

Someone has to take the risk and contribute to price discovery, just like someone has to vote and contribute to elections.

Anonymous said...

I have grappled with this dilemma for at least ten years. I think in the end most people want to know what is their real contribution to society.
Like Ernie I think the liquidity argument is nonsense.
My problem with moving to becoming a fund manager is that in spite of your best efforts whenever money is involved, it will always bring out the worst in people. Those Market Wizard books have a few examples of guys going out on their own and as soon as a drawdown came along investors got nervous and gave these guys all sorts of grief. Also the legislative and regulatory hurdles you have to go through are unappealing.
Instead I have decided my contribution should be to give more to charity than the average person (and I mean a lot more).
Yes you can do that with any paid job, but with trading I expect to make a lot more than if I have a job, hence I have a lot more disposable income – because I haven’t built a lifestyle based on my peak income
When the market turns bad charitable contributions reduce from the population, putting pressure on the good work of these organizations. For lots of reasons people fall through the net and it’s the charities that have to look after them.
So I’m trading because I want to be free of office politics, but my contribution to society is I am giving a lot more to charity than 90% of the population, thus helping others.

Paul Teetor said...

For me, supporting my wife and children is a pretty good goal, too. And it's cool that trading from a home office lets me spend a few extra hours with my kids instead of commuting. Maybe it's not a lofty aspiration, but it works for me.

Paul

Blank Reg said...

Honest economic risk is ultimately value-producing, in aggregate. You may see it as a zero-sum game, but unless you are running some type of scam in which fraud is involved, then in the big picture, you are part of the social system that increases total value, efficiency and creativity. IMHO.

Ernie Chan said...

bwc2000,
I certainly agree that compensation should be based on absolute performance. No reason to get paid by the return of the market index!

However, I think a modest management fee is fair. In fact, it can be in the interest of the investors to pay this management fee just to keep the managers in business (and pay rent etc.) during an extended drawdown. Otherwise, the investors would have made the decision in advance that a fund should shut down immediately whenever there is a X-month drawdown, which I don't think is their actual intention. (They could simply have redeemed their investments if that were the case.)
Ernie

Ernie Chan said...

Andrew S,
Certainly one should not exceed the strategy's capacity when starting a fund. Similarly, one should not be a fund manager when it turns out that one is incompetent in managing other people's money. But this does not contradict the overall principle that "if and when your trading strategies and business acumen is good enough to manage other people's money, it is a benefit to society that you do so".

I have dealt with the price discovery argument partly in my main article already. Imagine that important bad news on IBM is just released. All the day traders jump in and short the stock. So quickly, the price of IBM dropped 10%. Who benefited from this "price discovery"? Certainly not the long-term investors in IBM -- they had not had the chance to liquidate their holdings in an orderly way before getting pummeled, and will reduce their appetite for this stock due to the increased risk, despite the possible long-term growth. Certainly not the IBM employees or management -- they already know that the company value will sooner or later take a hit. Perhaps you can argue that some eager long-term investors on the side lines can now quickly jump in and buy the stock on the cheap. But couldn't they wait for a few days? What is the real benefit to society that they should buy this stock the next minute, rather than the next day? Is there no benefit for everyone to calmly and slowly analyze the real implications of the news and make a calculated decision? Do the momentum traders really know what the "best" price should be? So I don't see any societal benefit of the so-called price discovery mechanism on the time scale that day traders are used to.
Ernie

Ernie Chan said...

Anonymous,
I agree that donating to charity is another way in which a trader can be a do-gooder, provided that you believe your skill in picking a good cause is better than that of the potential investors in your fund, or that your potential investors may not donate to charity at all!

I had that point in my notes, but thought it would make my article too long, and obscure the main point. Thanks for pointing it out.

Ernie

Ernie Chan said...

Paul,
Certainly supporting your family is a good cause! But if you are doing well in this direction, perhaps extending your skills to helping out the extended family would not be too drastic a step?
Ernie

Paul Teetor said...

Thanks, Ernie. That's a great postscript to my note. You're right. - Paul

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Anonymous said...

Perhaps a more pertinent question is: Do Traders need to compensate their activities with more "do good-iness" than the average?

No!

I pay taxes; infact I pay more taxes, both in relative and absolute terms, than the vast majority of white (& blue) collar workers. Moreover, I (and my family) are far, far less a burden on the state.

The things I do to earn the money to pay these taxes are generally seen as "bad guy" things to do, mostly by people who don't understand. Markets exist for the tranfer of risk - take out the speculative community, and they don't work.

Thats it; ceteris paribus, I punch above my weight in the "contribution to society" stakes.

Greg said...

Hi Ernie,

On a scale less grand than helping "society" I think that successful traders can give back by helping/teaching other traders. Helping people make a living is admirable (IMHO). Your book and this blog are good steps in that direction.

Regards,
Greg

Ernie Chan said...

Greg,
You are very kind. But doesn't helping one group of traders profit simply mean taking money from another group of traders? And how would I know that the traders who read my book are all good guys that deserve to be rich? :)
Ernie

Greg said...

Hi Ernie,

Good point; helping one group of traders comes at the expense of another group. However, it seems to me that this is also a problem faced by a portfolio manager attempting to "do good". Making money for ones clients takes money away from someone else - it is difficult to know if this is a net societal benefit. Your clients will be better off, while those who invest with another manager will be less well off.

It is an interesting question (unfortunately I'm not yet in the position where it is personally relevant :)) and refreshing to see people thinking about it! Kudos.

Regards,
Greg

Ernie Chan said...

Hi Greg,
I think the situation is a little different with regard to fund management. If my strategies are working better and taking away profits from clients of another fund, then those clients are free to defect to my fund and benefit from my profitable strategies. Since I believe that I am not a crook nor a charlatan, I would be doing those clients a service too, and thus increasing the net benefit to society!
Ernie

Rookie said...

In the FX world I think we generally forget about large corporations that need to hedge against currency losses.

These companies are not concerned about allowing traders to profit on their hedge as long as they are protected.

Try and convince me that insurance is not valuable.