Apple’s surge and descent became a fixture of the financial commentariat over the last couple of years. It was tough to make it a full day without hearing some discussion of the company’s stock price, products, or plans for the future (we even got in on the act here, here, and here). Now a piece from CNN Money has been making the rounds, detailing the rise and fall of a hedge fund/investing advice newsletter run by someone named Andy Zaky. His “hedge fund” – if you can call it that – made its rise and fall entirely through investments in the Cupertino company (can we call it a Hedge Apple Fund?), and the lurid details are enough to make even Josh Brown wince.
It’s tempting to just shake our heads in pity for the folks who were burned by this “expert” advice and move on, but reading the article it becomes clear that the mistakes in this case are the same ones that we run into over and over again with investors everywhere – even in managed futures. We think it’s worth taking the time to pick over the coroner’s report here and identify some of the bright red warning flags that should have sent investors running for their lives.
Know Your Exit
Getting into a trade is the easy part. Exiting before the music stops and the chairs are all gone is what separates the legends from the paupers. In the waning months, Zaky’s fund was evidently doing little or nothing to hedge against the possibility that his aggressive options trading strategy might go wrong. Granted, he was going long and short with his Apple positions, but the fund experienced troubling losses in March of 2012 that should have set alarm bells ringing.
Track Records Matter
There’s a reason why people want to see a solid record of performance before they invest – they want to know that a manager is more than just a flash in the pan. It’s why we don’t include managers for consideration until they have 36 months of performance data for us to review. And when it came to Zaky, a few right calls on Apple in a newsletter is no substitute for a track record. It can’t give you a sense of what happened between his calls: did he panic when it went down before going up? A track record is a vital source of information about a manger – and a newsletter service isn’t remotely the same as managing client money and going through all of the emotional and logistical stress that comes along with that. You can’t know whether his calls were dumb luck or skill.
As Nassim Taleb (among others) has pointed out – the skill of this guy’s 5 for 5 picks on Apple could have been nothing more than luck. With hundreds (or perhaps thousands) of people throwing out Apple price predictions, some of them were bound to be right, much like the proverbial dart-throwing monkey. Without a sufficient track record, that’s the chance you’re taking.
Greed Kills
At one point, the article estimates Zaky’s fund was up nearly 400%, before plummeting to a loss of nearly -93%. That’s not a -93% drawdown from the peak, either (which would equate to something like a -65% to -70% loss) but a 93% loss from the starting equity:
Whether it was his ego getting in the way or the intoxicating effect of a hot streak, the fund kept trying to hit a home run on every swing. In effect, his options strategy represented huge hidden leverage – and no matter how talented you are, no one can keep up a perfect record forever.
Setting a Line in the Sand
Most traders have some kind of line in the sand, a point at which they will simply walk away from a trade gone bad, no matter how smart it seemed in the beginning. This is always the risk of going with a discretionary money manager… there’s a chance they’ll get married to a particular trade, refuse to get out while it’s still possible, and go down with the ship.
We saw this a couple of years ago with Dighton Capital’s bet on the Swiss Franc. They remained in the trade (and in fact, doubled down) as the losses piled up. The thing is, even is the manager is proven right eventually (as Dighton was, and Zaky very well could be), being right doesn’t help you if you’re wiped out before you get there.
Style Drift
By the author’s estimation, Zaky wasn’t even following his own advice when it came to his Apple investments. His original advice had been steeped in caution, his newsletter emphasizing his belief in minimizing risk. But after a couple of stumbles in the fund, whatever caution had originally been there apparently vanished.
The problem here, of course, is that style drift is notoriously difficult to identify with a hedge fund. Fortunately, there are warning signs that due diligence can watch out for with CTAs to alert investors when a manager is no longer sticking with the strategy that they once did. Simply put, when a manager stops following their own advice, it’s probably a good time to locate and secure your emergency flotation device.
It’s sad to see people lose their retirement funds or their livelihoods on blowups like this, but at least when it happens to someone else, it gives us a chance to learn from their mistakes. And in most cases, we find that the post-mortem analysis reveals the exact dangers we warn about and watch for on a regular basis.