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Opalesque Futures Intelligence

Greg Smith's Why I Left Goldman Sachs Leaves Questions

Wednesday, November 14, 2012

While it raises real issues, one is left with the question: are these the best derivatives industry stories the guy has? Interesting to note how this derivatives professional was able to point to MF Global criminality in one sentence.

Book Review:

Greg Smith's Why I Left Goldman Sachs Leaves Questions

By Mark Melin

Excuse me for snoring during the first four chapters of Greg Smith's book "Why I left Goldman Sachs."

Stories of Mr. Smith taking the Series 7 test for the first time or his biennial apartment search were not as insightful as his two sentence description of MF Global, pointing right to the criminality: using customer funds to cover trading losses. MF Global is considered by some a classic tale of how criminality by a few has hijacked the financial system, so why didn't he drill down further? (It is interesting to note that Mr. Smith, like some knowledgeable financial professionals, are acutely aware of exactly where the criminality in the MF Global affair can be found. However, the issue with MF Global, like Watergate, may be in the cover-up. See related articles below.)

Mr. Smith's book attempts to read like an entertaining novel, which is where it misses. Even chapter five, "Welcome to the Casino," the story of a trip to Las Vegas, is reasonably bland based on the derivatives industry. Yes, it would be odd to let loose with your boss in the land flash and flesh. But he could have explored their personalities, the funny situations in more detail? What happens in Vegas stays there, as evidenced by Mr. Smith's book.

While the book was a sleeper in some spots more than others, it also provides interesting insight - but could have gone further.

The analysis of Hank Paulson's reasons for leaving Goldman to become Treasury Secretary - and the tax benefits of doing so - was classic cause for a chuckle. The takeaway is while Paulson was trying to do the right thing by leaving Goldman to serve, at the same time he profited in terms of market timing and tax treatment of capital gains. This might be considered classic Goldman, profiting on both sides of a trade. But can anyone fault Paulson? It's America. It was legal and didn't hurt anyone. A line might be crossed, however, when a powerful individual breaks the law, hurts others and damages markets and yet is not required to face justice.

With this in mind, perhaps the primary message is making money shouldn't come at the detriment of clients, as Smith asserts. He makes valid points regarding what is now legalized fraud and a cultural shift that has been noted by those inside Wall Street. Traders have taken over from bankers, a key moment in economic history. Good traders understand catastrophic risk exposure - and the benefit of a failure guarantee to backstop certain OTC SWAPs transactions. This becomes an issue in a debt crisis. Why didn't Smith dig more in this critical direction? "We don't want to be forced to clear all OTC SWAPs transactions," noted one exchange executive at a recent derivatives conference. "Some of those positions define the word toxic." While exact EU SWAP risk exposure to a European debt crisis is yet to be transparent, the issue has been hotly discussed in the regulated derivatives industry.

Speaking of transparency, Smith could have explored other real OTC issues in detail. On page 74 he launches into a delightful section on the derivatives industry in the pits of Chicago - a bygone era, to be sure. Here's the miss: When he talks about a transparent style of trading, why doesn't he tie it into the battle that has taken place over the last 20 years between opaque, unregulated derivatives and their transparent, exchange traded brother? This is a critical set up, particularly as the derivatives industry is on the verge of a historic shift and the equity market might exhibit a degree of heightened volatility in the future.

At the end of the day, Smith outlines key truths. Consider the "muppet" issue, where Smith alleges Goldman bragged about taking advantage of clients.

Proving Goldman employees might have widely used the term almost misses the point. If true, Goldman's use of the word "muppet" to describe taking advantage of unwitting professional investors is at least the politically correct version. "Rip the guy's face off" is the more vulgar but common expression used among hedge fund traders. This speaks to buyer beware. Note to unsophisticated users of derivative products: it's not a bad idea to hire an independent consulting firm with deep industry understanding to conduct an analysis of your derivatives management and related arrangements. Professional investors are called "qualified" for a reason.

Smith's book raises important issues, which is why his sometimes vilification in the press is interesting and in some ways similar to the select vilification of Neal Barofsky, author of Bailout or Shelia Bair, author Bull by the Horns. Call this what it is: attempts to shoot the messenger for raising valid issues about criminality that is creeping into financial services. Are those that raise a voice against criminality and corruption to be lashed while a criminal element receives preferred treatment?

In the end, Smith's book is worth the read, but the question is: did he shoot his only bullet in the New York Times editorial that spawned the book? That's the problem. It could have gone much deeper.

Late Breaking News:

Legendary Managed Futures Trend Follower John Henry Ceases Trading Operations

Managed futures trend follower John Henry announced that the firm will discontinue trading as of December 31, 2012.

Founded in 1985, the commodity trading advisor (CTA) was known for its long-term trend following program with an equally long tolerance for staying with a trend in the face of drawdowns, extended periods of loss. The firm was said to utilize a moving average cross method of trend following and preceded the celebrated trend following "turtles." Mr. Henry was known for statements that he cannot predict the future, but rather it is prices that predict the future, following a classic trend following mantra.

"John Henry was a founding CTA with business acumen," noted Bucky Iaascon, president Futures Funding and the founder of the Managed Futures Association, which has since morphed into the Managed Funds Association. "It takes more than trading skills to run a successful CTA business."

Numerous successful John Henry alumni learned the business working at the firm. This includes Ken Tropin (now at Graham Capital), Nathan Roberts (Bank of America Merrill Lynch), Bruce Nemirow (Capital Growth Advisors), Verne Sedlacek (CEO of the Commonfund), Mark Rzepczynski (CEO of Four Winds Capital Management), Ted Parkhill (CEO of Incline Investment Management).

On the business side the firm was led early on by ex Dean Witter executive, Ken Tropin, and their specialty was providing access to managed futures via what were known as "public funds" distributed by the major wirehouses. Distribution channel, strong marketing and attractive performance were the reasons for his early success. Merrill Lynch for many years was John Henry˘â‚¬â„˘s largest client. Ken Webster, named president of the firm in 2007, joined in 1995 after a stints working with PriceWaterhouseCoopers and then with Richard Donchian, considered the father of trend following and creator of the Donchian Channel, which essentially identifies a trading range for a given market.

Mr. Henry emerged on the managed futures scene at a time when the industry had a slight $1.4 billion under management. The industry has grown to over $325 billion in 2012, according to data supplied from BarclayHedge, making managed futures the fastest growing and largest alternative asset investment category. While some early trend followers, such as Winton Capital Management, are said to have adjusted their strategy to include relative value methods, Mr. Henry stayed true to the core trend following principles adopted by early trend followers. "Models we developed 20 years ago are still in place today," he was quoted saying.

According to various reporting databases, John Henry was down over 20% year to date and assets under management had been slipping from their 2004 peak of $3.4 billion under management. The market environment of price persistence, from which trend followers benefit, has been inconsistent ever since stellar performance in 2008.

"The detective in me takes pride at being the first person to publicly put John Henry opposite to Nick Leeson in the great zero sum game that was Barings Bank," said Michael Covel, who wrote on the topic in his bestselling book, Trend Following. "Leeson, the loser in that trade, made the front cover of Time Magazine. John Henry, the winner, was the great unknown at the time. It is ironic that his two World Series wins ended up far exceeding his trading fame."

In addition to operating a trend following CTA, Mr. Henry went on to own the Boston Red Sox among other sports interests. He is said to have brought his mathematical skills and sense for probability tables to overlay into the world of professional athletics.

Hurricane Sandy Impact on Managed Futures Trend Follower 2100 Xenon

By Jay Feuerstein

Sandy was not the only perfect storm of October as it proved to be a difficult month for the managed futures industry as a whole. Uncertainty over the election, the fiscal cliff and the path of economic growth led to market turbulence that baffled all but one of the eight models we trade. Still uncorrelated, the models took different paths intra-month but still suffered the same month end. In the Managed Futures (2x) portfolio, the only model that performed was the liquidity model, which arbs fair value of energy spreads in the delivery month. In the Long/Short Global Fixed Income portfolio, the only model to profit was the momentum dispersion model, which also trades spreads of like assets to exploit different paces of momentum. With respect to markets, those that should have made money in the wake of QE3 did so. Two-year maturities in the U.S. and the Eurozone performed well because they are the most sensitive to Fed Policy. The yield curve model, another policy-based model, was flat for the month. Trend-following models suffered. The best market for the month was the Korean Won. The Japanese market did well, as did the Asian equity indices. The most difficult markets were gold, and five and 10-year maturities in most countries. Going forward, the portfolio continues to predict economic growth in the midst of a bond rally - a rare occurrence but one certainly possible in this environment of endless monetary ease. Finally, the recent performance puts each of our programs in one of the largest drawdowns in the nine-year track record. Our research shows that these types of drawdowns are attractive entry points for investors.

Jay Feuerstein is CIO of 2100 Xenon and Bruce Mumford, who moderated a key panel at the FIA conference, is Director of Investor relations.

This article was published in Opalesque Futures Intelligence.
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