This is a transcript of the video below.
This video is for those investors interested in going deep inside one of the most prestigious and successful hedge funds ever assembled, SAC Capital. You’ll be introduced to the man behind SAC Capital, Steven A. Cohen, and get a front row seat at how he makes billions of dollars.
Specifically, I’ll walk you through the unique differences in his hedge fund’s structure and the significance that culture plays into his success. We’ll then look at his investment process – from the perspective of the firm’s analysts, to the traders, to the man himself. This will highlight the key ingredient that drives his superior returns and the one product he uses that separates him from most Hedge Fund Managers.
Finally, I’ll put it all together to reveal what most people don’t know about Steve Cohen. Steve Cohen makes Billions … by Losing – A LOT!
Who is Steve Cohen?
Efficient market and random walk theories state an investor CAN’T beat the overall market in the long run. Essentially, these theories believe technical and fundamental analysis are a colossal waste of time. Don’t tell that to any hedge fund manager whose very reason of existence is to outperform the overall market, or to generate “alpha.”
What do the facts say?
According to performance results within the hedge fund industry, alpha does exist. Over the years, we find a handful of hedge funds using different strategies consistently beating the overall market. However, while hedge fund results are readily available on a monthly, quarterly, or annual basis, we rarely get a glimpse into the manager’s alpha generating process or the inner workings of their strategies.
We’re left wondering how some managers consistently beat others, and specifically, what are their secrets?
With consistent outperformance over the last two decades, a handful of hedge fund managers have amassed immense fortunes. One in particular, Steve Cohen, has climbed the Forbes 400 list to become one of the richest men in the world. His returns at his hedge fund, SAC Capital, were astonishing – 29% annualized returns over 21 years. Just incredible!
Steve Cohen ranks as one of, if not, the best trader of our time. Yet he’s a very private man, who rarely talks about his returns and certainly not his process. This makes him a polarizing figure.
Wall Street is a competitive jungle. When someone trounces the competition the only question people ask is: How did he do it?
And not explaining the results usually leads to speculation on the validity of those results.
Steve Cohen and his hedge fund returns became the target of speculation many years ago – from outside investors, other hedge fund managers, and the media. By 2012, he even found himself in the crosshairs of the SEC facing serious charges. But after almost 4 years, in January 2016, he settled with the government neither admitting nor denying any wrongdoing.
Now, hubris often makes it easier for us to believe someone is cheating than to admit inferiority, or even worse, to succumb to the fact that we don’t understand. But just because a man is quiet about his process, doesn’t mean he’s guilty of bending the rules. And just because you don’t know, doesn’t always mean it can’t be explained.
There’s always a flip side.
What if I told you that Steve Cohen already gave us the pieces of the puzzle explaining his process. It’s just that no one’s been able to put the pieces together.
So why am I qualified?
I spent almost a decade at a top hedge fund with a similar style to Steve Cohen. But more importantly, years ago as a risk trader for a top investment bank, I frequently traded against Steve Cohen. I learned important lessons from that experience and became fascinated with the man who is often called “the Best.”
This video puts the puzzle together in detail and teaches you:
How Steve Cohen makes billions!
SAC Capital: Structure
To better understand the answer, we need to look inside SAC Capital. Starting with its structure.
Here’s a typical Hedge Fund investment structure filled with Analysts (Letter A’s), Traders (Letter Ts) and the Portfolio Manager (or the PM).
Analysts can be generalists, which means they can analyze any company. More often than not, analysts are tied to a specific sector such as Technology or Health Care. Traders are generally skilled in multiple products and asset classes. They streamline the execution process and assist both the portfolio manager and the analysts. The number of traders and analysts may vary, but this is the general idea. The PM manages the risk reward of the whole portfolio.
How is SAC Capital Different
SAC Capital looks a little more like this:
Analyst/Traders/and a PM grouped in a Pod. Each Pod is a team of people focusing on different sectors, asset classes and/or strategies, investing their own pool of capital and responsible for their own P/L. Ideas are developed within the pods and introduced by Wall Street’s brokerage community.
So where does Steve Cohen sit?
The Big Book
Of course – in the center. He created what was called the Big Book, a portfolio he controlled, which invested most of the firm’s capital. The WSJ outlined the Big Book here:
“Managers of SAC’s portfolios are urged to funnel their BEST TRADING IDEAS— usually involving an EXPECTATION OF A COMING PRICE MOVE — to founder Steven A. Cohen for trading in a multibillion-dollar account known as “The Big Book.” Employees detail these “high-conviction” ideas to Mr. Cohen in regular calls, and successful ideas can add millions of dollars to a fund manager’s bonus.”
In essence, Steve Cohen created a structure that could effectively funnel trading ideas received from Wall Street’s brokerage community or generated internally. The ideas would be vetted and ranked – with only the highest conviction trades passed on to the Big Book. These top ideas would be further analyzed by the Big Book’s team to determine the BEST trading ideas that were finally presented to Steve Cohen.
SAC Capital Trades “a lot”
How many ideas are we talking about?
Here’s an SAC Spokesperson in 2013:
“Our model is based on over 100 portfolio teams delivering a diversity of investment ideas resulting in our portfolios having thousands of different investments.”
Steve Cohen in a 1999 speech said it more succinctly:
“We trade a lot.”
To incentivize each step in the funnel, a monetary reward system existed for profitable ideas generated both internally as well as externally. Steve Cohen paid analysts higher bonuses if their ideas worked and rewarded Brokerage houses with greater commissions when they delivered profitable trading ideas. This structure of SAC – designed to receive, analyze, funnel, and then invest in thousands of ideas provides Steve Cohen with Edge.
SAC Capital: Culture
Next, we take a look at the culture within the firm. With millions of dollars at stake in bonuses, the ultra-competitive jockeying between analysts and PMs to get trades on the Big Book should be expected. But here, we’ll focus on a different aspect of the culture spawned by his investment style.
In a 1999 speech, Steve Cohen made that style clear:
“We trade fast. … It’s not growth investing. It’s not value investing. It’s short-term catalyst investing.”
Examples of catalysts can be:
- Product announcements,
- Analyst meetings,
- FDA decisions,
- Government announcements
- Economic announcements
Successful catalyst investing generally involves Target Stock Prices, Timing, and Confidence. So, while trading in and out of thousands of stocks, and millions of shares with catalysts, Steve Cohen always wants to know:
- Why will the stock move?
- When will it move?
- Which results move the stock up or down?
- How much will it move?
For Steve Cohen EVERY idea needs a catalyst (or an event). Why is that?
Catalysts cause movement. And movement creates opportunity.
Take a look at Chipotles chart, ticker CMG. Notice where the movement happens? Right around the earnings dates the stock tends to have outsized moves as the company releases new information, positive or negative, about the state of the business that needs to be digested by the investment public.
Steve Cohen invests in short-term catalysts. He ingrained a culture within the firm that made it very clear to everyone – opportunity lies in the CATALYST. His employees must find the catalysts, dissect them, and analyze every possible result. Once that is completed, then they figure out how to make the best investment.
Over the years, SAC groomed Wall Street to fully understand this type of trading. SAC’s brokers became their eyes and ears for these opportunities, essentially becoming an extension of their firm.
This culture keeps the firm focused.
SAC Capital: Process – Analysts
Within every great firm you’ll find great process. Let’s dig deeper on how these analysts find opportunity.
Conceptually, a stock price is the average of all possible outcomes expected by the market. The Green area has to equal the red area. Each one of these outcomes can be influenced by a variety of factors such as revenues, expenses, earnings, etc.
Opportunity exists when those market expectations don’t match your expectations. With the release of new information, catalysts can be the impetus for changing market expectations, thereby changing the stock price allowing you to realize profits on the Catalyst date.
Analysts and Their Models
Analysts around Wall Street create models with many different inputs to analyze the health of a company and to forecast the future success of it. Earnings and the potential of FUTURE growth – tend to drive stock prices – such that higher earnings growth generally leads to higher stock prices. When you find a discrepancy between your expectations and the market’s expectations embedded in Wall Street’s models then an opportunity exists.
When I first touched an iPod it had already been out on the market for 6 months with rave reviews and good sales. But only after using the product did it become clear to me that this would revolutionize the way we listened to music. I became a believer. The only question I had was:
How many will Apple sell?
What surprised me was how low the estimates were for future sales numbers of the iPod. Wall Street analysts were only expecting 2-3 million iPods sold in the next year. As a reference, I looked back to see how many Sony Walkman’s, which debuted in 1979, were sold around the 1980s — 100mm!
- Why wouldn’t Apple trounce that 2-3 million number?
- Furthermore, if the iPod numbers were grossly underestimated, how much could the stock move?
A Catalyst is Important
The Catalyst unveiling the answer was the upcoming earnings report. With greater than expected units sold, all these analysts would have to raise their projections higher which would raise their earnings numbers which would boost the stock higher.
Clearly, there was opportunity.
In hindsight, a tremendous opportunity as Apple beat their estimates quarter after quarter for the next decade driving the stock up over 10,000%. Over 400mm iPods were sold and the rest is history.
A Traceable Opportunity
But Steve Cohen’s analysts can’t just expect to be right, because Steve Cohen like most hedge fund managers is hyper-focused on avoiding large losses. He’ll always want to know: What is the downside if I am wrong?
Given these parameters Steve Cohen can determine whether the idea is a tradeable opportunity, which means there are differences in expectations AND the right balance of risk-reward in the trade. Where he can win big if he’s right, but only lose small if he’s wrong.
At SAC, the Trade Idea goes through various stages before Steve Cohen makes his decision:
- Ideas get Pooled together.
- Analysts Filter the ideas at face value for potential.
- They Research & Analyze them.
- Expectations are compared to Determine Potential Opportunity.
- Steve Cohen determines whether or not it’s a Tradeable Opportunity.
SAC Capital: Process – Traders
So, how are the firm’s traders helping Steve Cohen’s process? We stated that a stock price is essentially the average of all possible outcomes. But on any given day, a stock price is the equilibrium of the share’s supply and demand.
Market expectations don’t just exist within Earnings Per Share calculations and the company models used by the analysts. Traders can also gauge market expectations through sentiment indicators and market positioning. Specifically, potential imbalances of supply and demand by the weak hands (typically short-term traders) and Sticky Money investors (which are typically large longer-term investors). How these two groups react on the Catalyst date can have a significant effect on the stock price.
Traders Look for Clues
So, while Traders are helping with the hunt for ideas and catalysts, they’re also analyzing the temperament of the stock and how Wall Street is positioned.
Here’s an example:
Let’s assume that Wall Street’s long-term investors have yet to buy AAPL. We believe the iPod and earnings estimates are too low and the stock should trade higher. And let’s also assume many short-term traders didn’t think the initial boost that the stock received on the iPod release was sustainable. Remember, back then Apple wasn’t a darling stock like it is today.
Given this negative positioning in the stock – more short-term bets to the downside and a lack of long term bets to the upside – how would this analysis potentially affect the stock on the earnings announcement?
The Combination of Wrong Expectations and Positioning
If we’re right and earnings exceed expectations then it could exert explosive upward pressure on the stock! Why?
- Because all of those traders short the stock would be wrong and forced to buy their shares back.
- Long term investors seeing strong earnings growth would start to come into the stock with new demand further pushing the stock higher.
We’d be left to analyze if future earnings estimates were still too low.
In this case, not only will stronger iPod and EPS numbers move the stock higher towards our Target, but potential share demand from investors adds upward pressure as well. This is the main reason why stocks move beyond people’s expectations.
How Traders Use Technical Analysis
Technical Analysis plays a similar role in the process. It measure sentiment at certain price levels in the market.
Using the same Apple example: What if our expected Target price is a breakout above the old high in the stock?
In this case, the price action (the new high) would generally trigger more demand for the stock based on technical analysis. Again, greater demand for the stock causes it to rise.
Traders help the process by finding edge in:
- Market Positioning
- Sentiment Indicators
- Technical Analysis
SAC Capital: Process – Portfolio Managers
With information provided by the analysts and traders, Portfolio managers attempt to find trades with the best risk profile that fits within the portfolio. Specifically, looking for trades ideas with the best possible reward for the least amount of risk. Great portfolio managers are patient enough to weed out the best trades with the clearest parameters of risk reward and the highest confidence in the analysis.
While losses matter, a good PM understands that a great trade idea which loses money was still a great trade idea when it was implemented because of the process. Listen to what Steve Cohen says:
“I think about the risk. I think about the trade. I don’t think about the money.”
Steve Cohen has made a lot of money precisely because he doesn’t think about the money. He focuses on executing a winning process. And believe it or not, Steve Cohen makes Billions of dollars being right ONLY slightly better than 50% of the time. Now that’s an incredible statement! But how?
Leveraging the Math
Steve Cohen believes in data, which means data can provide him answers. Listen to him here:
“I compile statistics on my traders. My best trader makes money only 63 percent of the time. Most traders make money only in the 50 to 55 percent range. That means you’re going to be wrong a lot. If that’s the case, you better be sure your losses are as small as they can be, and that your winners are bigger.”
Given that his traders will only be right slightly more than half the time, he understands how important it is to find trade ideas with great risk reward. But he also knows that isn’t enough. How do I know this? Because he tells us so.
From SAC regulatory documents, we get another piece of the puzzle:
“SAC Capital says some of the firm’s investments in securities are also conducted on a highly leveraged basis….”
It’s difficult to make 29% annualized returns over 21 years being right slightly better than a coin flip. You need a little bit of leverage. Now let’s take a look at what that means.
Playing Heads or Tails
We’ll start with the game Heads or Tails. While it’s an easy game to play, there’s a valuable lesson that comes from it. When flipping a coin there are 2 possible outcomes, Heads and Tails, that are equal. “Equal” means that each outcome has a 50% chance of coming up.
What exactly does that mean?
Well, over the long run and continuous flipping, if you added up all of the times it was heads and all of the times it was tails you would get numbers that approach 50% each (although at any given time it may not be 50%). If you play Heads or Tails for money and win $1 when you choose correctly, and lose $1 when you fail to, then there is no expectation of profit. Because over time, as you increase the coin flips, you’ll win and lose the same percentage of time, and you’ll also win/lose the same amount of money.
I created a board we can look at that shows our potential returns if we played a game that expanded our chances of winning outside of 50%. It shows what will happen if we win anywhere between 30 and 60% of the time. Keep in mind, these are expected returns happen over time as you play the game.
On the left hand side, you can see that if we win, then we win $1. And if we lose, then we lose $1. Going across the top in green is the percentage times we win. You can see that at 50% the expected return is $0. That would be like playing Heads or Tails. Steve Cohen said that most traders win between 50 and 55%, so I highlighted that range. And we can see that the expected return of playing the game goes from 0% at the 50% win rate to 10% at the 55% win rate. That’s not 29%!
High Returns Need Some Leverage
Let’s assume he’s only keeping the best traders. This means his traders average near the 55% win rate (recall his best trader was at 63%). And let’s assume he’s 3X LEVERAGED – so instead of $1 he’s risking $3. Then, we can multiply the returns by 3 to find the new expected returns (this excludes the cost to borrow the money, but you get the point).
Notice the 55% win rate and 30% return. This is almost exactly what Steve Cohen annualized over millions of trades during a 21 year period.
Let’s go a little further.
The trades funneled to Steve Cohen don’t have win $1/lose $1 risk reward profiles. Remember, Steve Cohen is forcing his firm to look for trades that have maximum rewards with limited risks. Win $2 or even $3 to Lose $1 is a much better game to play than win $1 to Lose $1 given that you’ll be right just slightly better than 50% of the time.
If we changed the win-loss profile of the game, then the results would be different. For example, down the left hand side you’ll see wins of $1 to $3 while maintaining a lose scenario of $1. At the top we still have the winning %s. This produces a matrix of potential returns.
Let’s pick a few:
- If on average we win $2 when we win, lose $1 when we lose, and we win 53% of the time, then our expected return is 59%. Not bad.
- If on average we win $1.5 when we win, lose $1 when we lose, and we win 52% of the time, then our expected return is 30%.
- If on average we win $1.25 when we win, lose $1 when we lose, and we win 53% of the time, then our expected return is 19%. IF we leverage this portfolio 1.5x, then that’s 19% x 1.5, or 28.5 %.
Obviously, there are a lot of ways to get to 29% like Steve Cohen. The goal is to find trades that can move you further down the lower right hand corner. That’s where your winning percentage is high and your $ WIN is high vs $1 Loss. By using this matrix we can get a glimpse at how data can help you manage a large portfolio.
But, there’s more. In the SAC regulatory document stating his use of Leverage, we learn that Steve Cohen also uses options!
Many people don’t know that Steve Cohen started out as an options trader. Options are a product that offer asymmetric payouts. This means you can win much more than you can lose on any given trade.
In fact, there is unlimited upside when buying options. For example, it’s possible to find trades where the potential is $3… $4 … $5… or even $10 upside vs. only risking $1. Options are designed to reduce the risk of a trade while maintaining a disproportionate amount of the reward.
So, it should come as no surprise that Steve Cohen uses options to help manage the risk in his trades and uses them only when he sees opportunity. Here’s what a former SAC employee had to say:
“Another way to take advantage of idiosyncrasy would be to have the skill to develop cheaper hedges. That is, if other traders are avoiding a stock because they cannot figure out how to hedge their exposure, the ability to hedge would create an edge. One trader I spoke with who worked at SAC Capital said he believes this is part of SAC’s ability to beat the market.”
Of course it is.
Elite Investors Use Options
While many investors use options, only the elite investors understand how to use them the right way. They consistently make 300-500% returns on their options trades. That’s absolutely true. And if they average a $2.50 profit per every $1 spent on options, then these elite investors can make 75 to almost 100% return on that part of their portfolio.
These elite investors only use options when they expect an outsized move in the stock that the market isn’t expecting.
Because in those instances, the risk reward favors options.
The Greatest Trade Ever
You probably saw the movie: “The Big Short.” If you haven’t then you should. It highlights the greatest trade ever – where Hedge Funds made Billions!!!
Well, guess what?
It was an options trade. A trade with the payout profile of a lotto ticket, but with a very high probability of winning. This is a Hedge Fund manager’s dream come true. And for many it did!
Options used correctly with the right trade are the most powerful investment tool you’ll find.
Piecing It All Together
Steve Cohen is an avid poker player. Before finding his passion for stocks, he was the shark at the poker table and even acknowledged:
“Poker … was the biggest determinant in my learning to take risks.”
Poker players accept that they won’t win every game. They live by the understanding that poker is a skill game based on probabilities and math. To be successful over the long term, a poker player must attain Mathematical Edge. This means that they must continuously make the right move after considering the risk vs the reward.
Remember our board?
It’s using data to measure mathematical edge. And by landing in the expected positive return area, you shift the odds in your favor. Remember, you will lose at times (yes, even Steve Cohen loses). However, over the long run, what counts is the relationship between your average loss, your average win, and how often you win. Steve Cohen is playing the odds and letting his process work.
Steve Cohen Expects Losses
It IS absolutely possible to win less than 50% of the time and still be very profitable with Mathematical Edge. Let’s assume that you’re right only 35% of the time. However, when you’re right, you average a $2.50 gain. The other 65% of the time you lose $1.00. That’s still a 23% gain! This should show you why the process of trading and finding the right plays is very important. And why Steve Cohen is so successful.
Consider an article in the WSJ during the time SAC was being investigated by the SEC. Keep in mind, it was an attempt to show some level of unscrupulous behavior:
“To get a sense of SAC’s most timely bets, the Journal measured how often the investments were followed by single-day stock jumps of 15% or more in the following quarter, along with a stock gain for the quarter of at least 10%. It found 186 such instances over the six-year period, following news such as stellar earnings reports, takeover offers or drug-trial announcements.”
Steve Cohen Creates Mathematical Edge
The article did the trick. This damning information further cemented Steve Cohen as a “cheater.” But, consider the flip side:
“…the Journal analysis turned up plenty of failures, too. Using the same test of a one-day 15% stock move in the following quarter, the Journal found even more quick drops than quick gains during the six years.”
Yes, that’s correct!
When stocks made big moves, Steve Cohen lost more times than he won. However, considering what you’ve just learned, significant positive returns with these outcomes should no longer sound like unscrupulous behavior. Rather, it should sound like a winning trade idea process combined with the great skill of assessing risk reward.
Through the structure of his hedge fund, the culture he’s cultivated, the risk-reward process he implements, the data he collects, the products he uses, and by continuously investing millions of dollars reinforcing all of the above – Steve Cohen shifts the mathematical odds in his favor.
And just like winning at poker, Steve Cohen is a highly successful hedge fund manager because he creates MATHEMATICAL EDGE.
That’s how Steve Cohen Makes Billions!
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Or see if you can notice anything peculiar in Steve Cohen’s portfolio…