Dissecting Steve A. Cohen’s Edge

One of my discarded PhD chapter outlines was on the hedge fund SAC Capital and the insider trading case involving former SAC trader Matthew J. Martoma and the firms Elan and Wyeth. I had hypothesised that SAC founder Steve A. Cohen had developed a specific organisational strategic subculture. Recently, I read and analysed Cohen’s legal defence. Now, The New Yorker‘s Patrick Radden Keefe has written a lengthy article on SAC, Cohen, Martoma, and the insider case’s legal outcomes. I reflected on how Cohen developed his edge:

 

1. Cohen had ignition experiences early on in his career. Keefe and the PBS Frontline ‘To Catch A Trader‘ point to Cohen’s formative trading experiences with the investment bank Gruntal & Company as a likely first encounter with insider trading. Possibly more important to Cohen’s creative psychobiography are his early experiences in learning to perceive fluctuations in stockmarket prices, as told to Jack Schwager. This tape-reading ability has been part of trading education since Jesse Livermore and is echoed in the Market Wizards series interviews that Jack Schwager did with Michael Marcus and Paul Tudor Jones II. Cohen’s early experiences also parallel the role of ignition experiences in the literature on genius and creativity. They also meant that Cohen did not adopt the dominant approaches of fundamental and technical analysis. Instead, he anticipated behavioural finance in looking for catalysts that moved stocks and that led to rational herding and overconfidence behaviours he could trade against.

 

2. Cohen hired a performance psychologist. Keefe mentions but does not name the late Ari Kiev as the performance psychologist who Cohen hired to mentor his traders. Kiev’s books notably The Mental Strategies of Top Traders (Hoboken, NJ: John Wiley & Sons, 2009) draw on his SAC experiences and detail his personal synthesis of elite sports training, game theory, portfolio management, and leadership frameworks. Kiev foreshadowed other performance psychologists such as Brett N. Steenbarger who have worked with hedge funds. In doing so, Kiev and Steenbarger became de facto strategic foresight practitioners, albeit with a different knowledge base to futures studies.

 

3. Cohen created a specific organisational strategic culture. Keefe and PBS Frontline‘s narratives focus on SAC’s competitive culture between rival portfolio managers; the inside discussion of “black edge” as material non-public information; how Cohen ran his trading floor; and how Cohen got the best trading ideas from portfolio managers whilst also insulating himself from their information sources. There are observations here worthy of the third generation literature on strategic culture, and how specific organisations have developed ways to hedge risk and volatility. If Keefe had been familiar with the sociology of finance literature then he might have focused on this more. Now that SAC has transformed into Point 72 Asset Management – to manage Cohen’s estimated $9 billion wealth – we may never really know what went on inside SAC, unless there is further operational disclosure in civil cases, or in trader memoirs.

 

4. Cohen was pro anti-fragile. Keefe tells an anecdote about how Cohen would ask job applicants: “Tell me some of the riskiest things you’ve ever done in your life.” Keefe segues from this into an anecdote about insider trader Richard Lee. But there are several other possible ways to interpret Cohen’s question and why he would pose it to SAC job applicants. Cohen may have wanted to assess how the job applicant conceptualised risk; how they made decisions; and what specific decisions they made when faced by risk. As Kiev identified these are crucial aspects to successful trading. The anecdote also suggests to me that Cohen was pro anti-fragile: options trader and philosopher Nassim Nicholas Taleb’s term for phenomena that become stronger due to volatility exposure. Being pro anti-fragile – and taking considered risks – was in part how Cohen turned an initial $US25 million in the early 1990s into his fortune – as a possible successful example also of the Kelly Criterion risk management strategy.

 

5. Cohen factored in transaction and execution costs. Keefe alludes in passing to how SAC used dark pools – private exchanges that hedge funds use to trade their positions – in order to exit Martoma’s Elan and Wyeth trades. Kiev’s game theoretic reasoning about catalysts and other market participants provided one rationale that was influential in SAC’s organisational strategic subculture. Awareness of transaction and execution costs – and their impact on a trade’s profitability – provide another rationale. In one of the few public statements by SAC staff, Neil Chriss emphasised the importance of considering transaction and execution costs in his introduction to Robert Kissell and Morton Glantz’s book Optimal Trading Strategies (New York: AMACOM, 2003), pp. viii – x. Chriss suggested there was “an efficient frontier of trading strategies . . . Each strategy has a certain transaction cost and a certain risk” (emphasis original) (p. x). He then stated: “no institutional manager can afford not to understand transaction costs” (emphasis original) (p. x). In doing so Cohen anticipated the impact that dark pools, and algorithmic / high frequency trading have had on contemporary market microstructure.

 

There is thus far more to Cohen’s hedge fund success with SAC Capital – his sustained edge over two decades – than what the Martoma insider trading case has revealed to-date. Keefe’s New Yorker profile reveals aspects – but more trading knowledge is needed to piece together Cohen’s secrets from public information sources.

Steve Cohen’s Black Edge

Steve Cohen (Forbes)
Steve Cohen (Forbes)

On 19th July 2013, the Securities & Exchange Commission filed an Enforcement Notice (PDF) against SAC’s Steve Cohen, alleging failure to supervise the hedge fund’s investment managers. The SEC has targeted Cohen for over a year. Its pre-case featured in Charles Gasparino’s book Circle of Friends (New York: HarperBusiness, 2013). Veteran business journalist Bryan Burrough interviewed Cohen in 2010, and then looked at the US prosecution case in 2013. Cohen’s lawyers later released a ‘white paper’ rebuttal of the SEC’s claims (PDF).

 

Cohen has a fearsome reputation as a trader. He hired the late performance psychologist Ari Kiev to mentor traders, and featured in Kiev’s book The Mental Strategies of Top Traders: The Psychological Determinants of Trading Success (Hoboken, NJ: John Wiley & Sons, 2010). But now the SEC claims that Cohen’s trading prowess comes from ‘black edge’: insider trading based on material, non-public information from expert networks and other sources.

 

The case is filled with interesting details for hedge fund and trading watchers. It might become a PhD case study or academic paper for me.

 

Reuters’ Felix Salmon has a great overview of Cohen’s influence and why the SEC’s case may shake up hedge funds:

 

Cohen has never been easy to invest with. He deliberately charges some of the highest fees in the industry — his 3-and-50 makes the standard 2-and-20 seem downright generous. And even then it has historically been very hard to get him to agree to manage your money. Cohen makes his fund inaccessible for a reason: he knows how hard it is to scale the astonishing results he’s been posting, year after year, and that at the margin, the bigger he gets, the lower the returns he’s likely to see.

But at the same time, there’s no way that he can run a $15 billion trading book on his own. He has roughly 1,000 employees, of which about 300 are investment professionals. And if you’re one of those professionals, you have one of the hardest jobs in the business.

The way that SAC works is that Cohen gives his individual traders, and teams, their own trading accounts, with millions or billions of dollars: the traders who make the most money get the biggest allocations. Traders get paid a percentage of the profits they make, which makes them compete against each other: in order to be successful at SAC it isn’t good enough to make good profits. Instead, you have to make better profits than any of the other traders — who themselves are some of the best in the business. If you can’t do that, you get fired. If you can do that, you get to manage ever-increasing amounts of money — plus, Cohen will mirror your positions in his own account, the largest at the firm, giving you a shot at extra profits over and above the ones generated by your own positions. In the immortal words of David Mamet, first prize is a Cadillac El Dorado. Second prize is a set of steak knives. Third prize is you’re fired.