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.

We Are All Traders Now?

Mark Pesce pointed me to Bernard Lunn’s article which contends netizens now live in a real-time Web. Lunn suggests that journalists and traders are two models for information filtering in this environment, and that potential applications include real-time markets for digital goods, supply chain management and location-based service delivery.

Lunn’s analogy to journalists and traders has interested me for over a decade. In the mid-1990s I read the Australian theorist McKenzie Wark muse about CNN and how coverage of real-time events can reflexively affect the journalists who cover them. As the one-time editor for an Internet news site I wrote an undergraduate essay to reflect on its editorial process for decisions. I then looked at the case studies on analytic misperception during crisis diplomacy, intelligence, and policymaker decisions under uncertainty. For the past year, I’ve read and re-read work in behavioural finance, information markets and the sociology of traders: how the financial media outlets create noise which serious traders do not pay attention to (here and here), what traders actually do (here, here, and perhaps here on the novice-to-journeyman transition), and the information strategies of hedge fund mavens such as George Soros, Victor Niederhoffer, David Einhorn, Paul Tudor Jones II and Barton Biggs. This body of research is not so much about financial trading systems, as it is about the individual routines and strategies which journalists and traders have developed to cope with a real-time world. (Of course, technology can trump judgment, such as Wall Street’s current debate about high-frequency trade systems which leaves many traders’ expertise and strategies redundant.)

Lunn raises an interesting analogy: How are journalists and financial traders the potential models for living in a real-time world? He raises some useful knowledge gaps: “. . . we also need to master the ability to deal with a lot of real-time
information in a mode of relaxed concentration. In other words, we need
to study how great traders work.” The sources cited above indicate how some ‘great traders work’, at least in terms of what they explicitly espouse as their routines. To this body of work, we can add research on human factors and decision environments such as critical infrastructure, disaster and emergency management, and high-stress jobs such as air traffic control.

Making the wrong decisions in a crisis or real-time environment can cost lives.

It would be helpful if Lunn and others who use this analogy are informed about what good journalists and financial traders actually do. As it stands Lunn mixes his analogy with inferences and marketing copy that really do not convey the expertise he is trying to model. For instance, the traders above do not generally rely on Bloomberg or Reuters, which as information sources are more relevant to event-based arbitrage or technical analysts. (They might subscribe to Barron’s or the Wall Street Journal, as although the information in these outlets is public knowledge, there is still an attention-decision premia compared to other outlets.) Some traders don’t ‘turn off’ when they leave the trading room (now actually an electronic communication network), which leaves their spouses and families to question why anyone would want to live in a 24-7 real-time world. Investigative journalists do not generally write their scoops on Twitter. ‘Traditional’ journalists invest significant human capital in sources and confidential relationships which also do not show up on Facebook or Twitter. These are ‘tacit’ knowledge and routines which a Web 2.0 platform or another technology solution will not be the silver bullet for, anytime soon.

You might feel that I’m missing Lunn’s point, and that’s fine. In a way, I’m using his article to raise some more general concerns about sell-side analysts who have a  ‘long’ position on Web 2.0. But if you want to truly understand and model expertise such as that of journalists and financial traders, then a few strategies may prove helpful. Step out of the headspace of advocacy and predetermined solutions — particularly if your analogy relies on a knowledge domain or field of expertise which is not your own. Be more like an anthropologist than a Web 2.0 evangelist or consultant: Understand (verstehen) and have empathy for the people and their expertise on its own terms, not what you may want to portray it as. Otherwise, you may miss the routines and practices which you are trying to model. And, rather than commentary informed by experiential insight, you may end up promoting some myths and hype cycles of your own.