The following is a fantastic speech from Bruce Kovner on Caxton Associates’ 20th anniversary. Kovner shares a plethora of trading wisdoms including the three most important contributors to his hedge fund’s success. You can read the original speech from 2003 here.
To all my colleagues, to friends and associates who have worked and invested with us over the years, may I say welcome to this 20th anniversary party. This is the first time Caxton has thrown a party for our extended family and I am happy and thrilled to welcome all of you. If we are able to catch Peter D’Angelo in a generous moment, we may not have to wait another twenty years for the next event!
This particular room has always been one of my favorites – combining a modern space with the elegant and mysterious beauty of this ancient Egyptian temple. But this setting also suggests another theme: that nothing is permanent in human affairs, that the apparent solidity of these stones of Egypt counted for nothing as dynasties came and went and especially when the Pharaoh of the 1950’s and 60’s, Gamal Abdul Nasser, now himself long gone, determined that the great Aswan Dam would flood the plains of the Nile, submerging much of Egypt’s history in the vast lake then to be formed.
The World changes. In some small sense, Caxton’s story has its roots in similar observations. Caxton was born twenty years ago amid extraordinary changes in the world of money, finance, and politics, changes that have helped transform the world economy. Tonight, I would like to talk briefly about the circumstances both in the markets and in my own life and experience that have shaped Caxton’s performance over the last two decades. I would like to start with events that predated the founding of Caxton but which are important in understanding the origins of the company. Then I would like to describe important periods in Caxton’s evolution and close with some thoughts about the future.
Caxton was started in a period of economic transition – a time of creative destruction, as fans of Professor Schumpeter would say – when the old order of fixed exchange rates and fixed gold prices ($35 per ounce, I believe) could no longer contain the enormous pressures of the 1960’s and 1970’s. We wanted guns and butter, Vietnam and the Great Society. Around the world there were vast and differentiated changes in inflation, productivity, and wealth. So, the Gold window was shut in 1968. Three years later, Richard Nixon abandoned fixed exchange rates and let the dollar float. A new economic era had begun.
The inflation, volatile exchange rates, rising commodity prices and high nominal interest rates that followed in the 1970’s created an environment in which the old ways of investing no longer functioned well. Long-only stock and bond trading were not the optimum ways to capture the opportunities that the 1970’s created. On the contrary, between 1968 and the early 1980’s, stocks and bonds suffered through a long bear market, destroying the value of equity and bond portfolios and undermining confidence in traditional investing styles. On the other hand, opportunities to profit from being long or short in currencies, fixed income, stocks and commodities abounded. The stage was set for active ‘macro trading’ as the increasingly popular term would label it.
New York, with its long-only equity culture and preponderance of establishment institutions, was not a congenial host for the new trading culture. That had to emerge in Chicago where people like Leo Melamed, a former egg broker, became head of the Chicago Mercantile Exchange and initiated trading of financial futures. The Chicago Board of Trade followed suit with the establishment of a market for trading Ginnie Mae futures. The process of creative destruction operated on the structure of financial markets far more effectively on the frontier in Chicago than it did in New York.
Cambridge, Massachusetts in the 1960’s was also not a bad place to learn that innovation and change are at the heart of survival. I had learned some of that from the history of my family – Jewish refugees from Czarist Russia. But I learned more after I enrolled as a freshman at Harvard College in 1962, reading Schumpeter on “creative destruction”, Keynes and Samuelson on counter cyclical fiscal policy, Tocqueville on the Ancien Regime, Fainsod on the Russian Revolution, Keynes (again) on the Economic Consequences of the Peace (meaning the punitive Treaty of Versailles), and a range of historians on the two World Wars. All were lessons on the impermanence of institutions and on the unintended consequences of government policy.
I did not know that these lessons were going to be put to any practical use by me. I had thought I would enter government service, not the financial world, when I left graduate school in 1970 and began to wander around the world for a few years. When I finally moved back to the United States in 1974, I was not seeking a Wall Street career (and I had no qualifications to begin one). I taught politics during the day and began to study financial markets at night. And by 1977, when I made my first tentative steps into financial markets, the financial world had already begun its remarkable transformation.
In my one-bedroom apartment on 57th Street, down the block from Carnegie Hall, I was only four miles away from Wall Street but a universe away in terms of my approach to markets. The new world of financial futures reduced the barriers to entry to currency and interest rate markets. Perhaps, I thought, efforts to understand what moved these markets might be well rewarded. I speculated on commodity prices, interest rates, currencies and was gratified to make money. And I found my way to Commodities Corporation, started by economists from MIT and Princeton, to learn more of my newly chosen trade. After five and a half years, with the blessings of my former employers, I decided to establish a company that reflected my own particular vision of how to adapt to this new financial world. With $7MM from investors and $5MM of my own funds, I started Caxton in March of 1983.
The new company’s operations were guided by principles and observations that helped us to pursue successful trading.
Barriers to entry to financial markets of all kinds were coming down. New markets were developing for the new financial instruments. Early providers of liquidity and expertise were likely to find excess returns.
Analysis of macro conditions was not being done systematically or well in most large money market institutions! Good analysis would provide excess returns.
Exogenous shocks – say, for example, oil price shocks – to the economies of the world were likely to be numerous. Being a quick responder to these shocks would provide excess returns.
Most investment managers and operators in equity and debt markets had institutional and cultural restraints on the kind of trading they could do – and tended heavily to favor long-only approaches. Few traders were highly skilled in the use of derivatives. Excess returns were therefore more likely to be earned by those who could go short as well as long, and who could use derivatives well.
More generally, Caxton adopted an institutional model that built in more flexibility in the creation of optimal portfolio mix than was normal on Wall Street. We had three structural advantages: First, there were no institutional limits on the range and style of our trading. We would go to any asset class where we saw opportunity, and we would trade in a range of trading styles (long, short, differential based, trend-following, mean-reversion, or arbitrage to name a few). Second, we chose to target risk levels, not nominal dollar levels, to calibrate our trading size. This enabled us to use leverage and portfolio theory to optimize our risk profile. There is plenty of opportunity to do risk management badly, of course; but the advantages of doing it well were enormous. And thirdly, we believed in a process of dynamic risk allocation – that is, we would put more capital at risk when either market conditions or macro economic conditions convinced us of the possibility of excess return. Caxton wouldn’t be stuck with a fixed asset allocation to stocks or bonds or currencies or commodities. We would change our capital allocation with conditions. Do that well and returns would not be a passive captive of the business cycle. On the contrary, dynamic capital allocation could turn what was for more inflexible institutions a source of difficulty into an advantage for a young firm capable of adapting to changing conditions.
The first ten years of Caxton’s existence certainly provided ample opportunity for us to test both premises of our new model and our skills in deploying it. We had macroeconomic shocks aplenty – rising and falling rates, oil shocks, the Plaza accord, the market crash of 1987, the Iran-Iraq War, not to mention the first US-Iraq War. We had new markets, new financial instruments, new Presidents, new Prime Ministers, currency unions … No shortage of fun, for we dyed-in-the wool macro traders. And, fortunately, although we made many, many mistakes, we managed to execute well enough to have good returns. During the first ten years of its existence, starting with about $10MM in capital, Caxton earned some $3 billion in profits, with a gross trading return of 55.6 percent per year. In the same period (although it included nearly all of the first ten years of a great bull market) the S&P 500 grew at the rate of about 15.7 percent per year. And even though Caxton’s trading during those years felt, to me, a little too much like Coney Island’s Cyclone roller coaster, the quality of our return, with a Sharpe ratio of 1.68, was about three teams higher than the S&P’s .54 during the same period.
Our success notwithstanding, by the mid-nineties, several of the opportunities which had facilitated Caxton’s success had changed. A large number of new players – hedge funds, prop desks at banks, speculators – had entered the market, reducing the advantages of early entrants. Macro analysis had become routine in wire houses, investment banks, and prop desks. And Caxton, with $1.6 billion in assets, was no longer small enough to make its returns with quick trades in smaller markets. We felt stale. Our performance – down 2.4% in 1994 – felt awful. It was time for a change. We sent our investors 60% of their funds, reduced our capital to $650MM, and went back to the drawing boards.
Prior to 1994, Caxton was largely focused on top-down macro trading. By 1994, we had concluded that we needed more tools than those that macro trading provided. Nothing works all the time. We wanted a variety of trading strategies across all liquid asset classes. And we didn’t want to be confined to one trading style, such as momentum-based trend following. So we began a systematic process of searching for new strategies, new styles, new markets and new traders. Let 1000 flowers bloom, it was said. But make sure they bloom with good risk management, and with low correlation! In the years since 1995, Caxton has spent a lot of time searching for these techniques, strategies and traders. We kissed a lot of frogs, as my good friend Joe Grundfest might say. (Actually, does say.) And we wound up with some 50 trading centers covering virtually all liquid asset classes, employing a multiplicity of approaches – trend following, of course, but also mean reversion strategies, fundamentals based models, arbitrage, computer-based approaches to markets, discretionary trading of equities, active trading of mortgage markets and related instruments, and many others.
We wouldn’t be here tonight, having this rather wonderful celebration in the Metropolitan Museum, if the results of that effort had not been acceptable. In fact, since January 1995, Caxton has earned $8.5 billion in trading profits, starting with a base of $650MM. Our average annual return has been 33.1 percent, and our Sharpe ratio rose from the first decades 1.68 to just below 2.00. In the same period, the S&P’s annual return was 12.7% for the S&P, with a Sharpe ratio of .50.
Today, Caxton has nearly 50 trading centers, divided among:
Macro oriented centers, which deploy about 35% of the risk of the company;
Equity oriented centers, which deploy about 25% of our risk;
Quantitative systems, deploying another 25% of our risk; and
Fixed income strategies which deploy another 15% of risk.
My own role in all of this has changed substantially over these years. Whereas in the first years of Caxton, I had tactical responsibility for almost everything in the portfolio, my trading accounts for something like 10% to 15% of the company’s risk presently. I spend a great deal of time on strategic development. It is more important for me to help find and develop areas of opportunity than it is for me to trade them. And it is more important to have a robust process of strategic development than it is to have one dependent on one human being. That is why Caxton devotes many millions of dollars a year to research and development aimed at finding new quantitative techniques or new areas of trading likely to yield high returns, and developing information technology and risk control techniques. I spend most of my time on these efforts, and on working with traders when they need advice, encouragement or help.
In these efforts, I try to pass on something of the proverbs, ethos and culture of trading that I have regarded as essential to Caxton’s success. Of these, I will mention three:
- Listen to the market. Close observation of price behavior is always necessary for the discipline of successful trading and it is very often very helpful in providing evidence about the nature of current conditions. If we can understand what the market is telling us, we will most likely be able to understand how to trade it. Listen to the market, hear it, don’t tell it what to do. Listen.
- Take politics and policy seriously. Changes in policy matter. Changes in leadership matter. Study them seriously. This doesn’t mean that politicians and policy makers will get it right – indeed very often they will get it wrong and these ‘mistakes’ in and of themselves may be important to markets. But ignore them at your peril. Policy matters. Politics matter.
- Above everything else, never let the discipline of risk control become lax. Those 100-year storms have a way of coming round every few years. If in real estate it’s “location, location, location”, in leveraged trading it is “risk control, risk control, risk control”. It is surprising how often this focus is lost.
Listening to the market. Taking politics and policy seriously. Risk control – to these we need to add one more on the level of the firm. And that is our old friend “creative destruction”: the process of creative destruction operates on trading techniques (and their embodiment in individual traders) as much as it does on any market structure. Any trading technique has a finite life in which it yields extraordinary returns. As more capital and knowledge are applied, markets become more efficient and rates of return drop – until eventually high risk adjusted returns disappear. Then it is time to retire the technique and move on.
The flexibility and learning that must be applied to trading also should be applied to capital allocation. We can’t be static in how we allocate capital to a particular strategy, nor to all of them together. So Caxton only wants the amount of capital it can deploy successfully. We are not asset gatherers. Despite a long list of investors who want to get in to Caxton funds, we will most certainly send money back to investors again in the near future. Barring unforeseen developments, we will return between 10 and 20% of our capital to investors at the end of this year. Flexible capital allocation. When rate of return drops, send capital back home to our investors.
In the meantime, we will continue to develop new techniques and new trading centers. As they bear fruit, we will nurture them and introduce them into our portfolio as they are proven and as conditions permit.
There is little doubt in my mind that the financial markets will remain as dynamic in the next twenty years as they were in the last. Look at the enormous changes in Asia, where China is emerging as a giant already. One cannot understand world commodity markets today without understanding China – and therein, of course, lies much opportunity as well as risk. Look at the extraordinary long cycle in Japan. Twelve years of recession and decline, of policy mistakes, of opportunities lost. And perhaps now, finally, of some policy initiatives which may finally lift Japan deflation and seemingly unending recession.
And one doesn’t have to look only across the oceans for big structural changes that make markets different in this decade than in the last. Look at the fixed income market, where mortgages and floating rates have changed the character of supply and demand and market behavior in recent years. The mortgage market now dwarfs the U.S. Treasury market. Outstanding mortgage debt now exceeds total marketable Treasury debt to 50 percent. A decade ago that rate was reversed. No one can understand the path of yields in the United States without understanding these new conditions.
And look at the universe of possible exogenous shocks we confront today. Perhaps we all have some sense of the potential disturbance of terror attacks. But have we correctly priced them in the market? How do you price low probability high damage events? And how do you know the right probabilities?
And what about technological change, which still promises to create enormous values (I am thinking now of biotech as well as information technology)? And what about new oil shocks? Or geo-political conflict, such as India-Pakistan?
Clearly, this list could go on and on.
There is no certainty that Caxton will be able to adapt successfully to these and other risks and changes, but we do structure ourselves to be able to analyze such changes and risks and try to respond to them. And certainly those institutions which do not have the capability to respond leave themselves at the mercy of events. The premise of our operational philosophy was always and still is: The World Changes. Nothing is Permanent. Those who fail to adapt to change risk everything. Look around you, here in this beautiful room. Look at the magnificence of the Temple of Dendur and of the civilization of Egypt. The World Changes and nothing is permanent. If that is one of the lessons that family history and education taught me, it is also the lesson that imbues the practice of Caxton. Study the world. Study markets. Listen to the markets. Then, perhaps, with a little luck and skill, you may be able to find ways not simply to be a victim of circumstances but to profit from them.