Economics & Growth | Monetary Policy & Inflation
Podcast Transcript: Sean McGould on Creating an Investing Edge, Hedge Funds and Inflation Opportunities
- By Bilal Hafeez
- 40 min read
This is an edited transcript of our podcast episode with Sean McGould, published 30 June 2023. McGould – the founder/CEO of the Lighthouse Group – a $15bn investment management firm. Prior to Lighthouse, Sean was the Director of the Outside Trader Investment Program for Trout Trading Management Company. Before joining Trout, he worked for Price Waterhouse in auditing and corporate finance. In this podcast, we discuss how accounting knowledge helps investing, the evolution of the hedge fund industry since the 1970s, getting alpha from shifts in regulation, and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.
Introduction (0:00)
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Bilal Hafeez
Greetings and welcome, Sean. It’s great to have you on the podcast. I’ve been looking forward to our conversation.
Sean McGould
Thank you. Thank you for having me. I appreciate it.
Bilal Hafeez
Now before we go into the heart of our conversation, I did want to ask something about your origin story. What did you study at university? Was it inevitable you’ll end up in finance and some of the key milestones you’ve had of your career until now?
Sean McGould
I think it was a little bit inevitable that I would end up in finance. I spent the latter part of my teenage years growing up just outside of Chicago, and the neighbourhood that I lived in there were a few of my neighbours that traded commodities on the Chicago Mercantile Exchange, and even before that, I was very interested in the equity markets. Purchased my first stock when I was 14, was always very interested in financial markets, but really became enthralled with them when I moved to Chicago. I ended up going to university and studied actually accounting, always knowing I wanted to get into finance and ended up working for Price Waterhouse for three years after I graduated and that was a great experience. Learned a lot both in auditing and corporate finance.
And then was really fortunate back in August of 1993 to land a job with Trout Trading, which was a commodity trading advisor that was based in Chicago at that time, but was moving out to Bermuda and did short-term systematic trading internally. The specific role that I was hired to do there was to take some of the excess margin capital and allocate it to external trading managers. My job was to find other traders, deploy that capital and really loved that job, but really my background and passion since I was a teenager, I really loved the markets and I’ve been very fortunate to know what I wanted to do for a long period of time.
How Accounting Knowledge Helps Investing (3:05)
Bilal Hafeez
And the accounting background. That’s interesting. How have you found that to be helpful in your career?
Sean McGould
I think that accounting is a real discipline in terms of learning how balance sheets and income statements and flow statements are put together. I think it gives you a very good foundation to understand, one, how businesses work, two, how processes work because part of trading and investing is a process. You have to put the trade in, you have to account for it, you have to finance it, you have to reconcile it, you have to value it. All of these things you learn in accounting.
And also at Pricewater I was fortunate they were just starting up their corporate finance group about the last 18 months that I was there, and what the corporate finance group really did was special projects, was going into situations where there was either merger, divestiture, some change within the business that we needed to do some specialised either auditing work, accounting work, valuation work. That was great to get ready for the markets because the projects were very varied in their nature. I was only 22 years old at the time, so I was really fortunate to be part of that group and get some exposure, and then I was extremely fortunate to join Trout in August of ’93.
Bilal Hafeez
And when you said you joined Trout, was that in Chicago, Bermuda? Where did you end up going?
Sean McGould
I knew I was going to be moving to Bermuda, but I started in Chicago and that’s where I started. I was actually going to get my MBA at night at the University of Chicago, and I remember interviewing at Trout and basically Monroe at that time, so that really wasn’t necessary to work there and needed to move out to Bermuda. Went and spoke to the folks at URA Chicago, they said I had seven years to finish up if I needed to, and went out to Trout. Never finished my degree. It was 13 or 20 courses through, but I think the training and experience I got at Trout was really what I wanted to go do and pursue it. It was a fantastic experience. People at University of Chicago they gave me great advice as well. They’re like, ‘If this is really what you want to do in pursuit of your MBA, then you should just go do it and come back if something doesn’t work out or you want to finish your degree.’ So, I’ve been really fortunate with good mentors and good advice in my life.
Bilal Hafeez
And this as a side note, what was it like living in Bermuda?
Sean McGould
Well-
Bilal Hafeez
Because obviously you spent a lot of time in Chicago in a major city and then moved to Bermuda. That’s quite a shift.
Sean McGould
I grew up half my life in New Jersey and half in Chicago, so first thing I realised was the weather was a lot better. The second thing was the job was really challenging, so this was really at the beginning of the hedge fund industry, some of the strategies that were being used and I was fortunate to be able to look at all of those strategies and I was surrounded by a group of people that were about the same age. Everyone I would say was younger than 30 years old at that time. The fund at that point in time was probably about 400 million dollars. Monroe was brilliant, interviewed in the Market Wizard, so it was fantastic to work for, placed a lot of trust and responsibility. I enjoyed living there and really enjoyed working for Trout, but after three years I did want to leave the island. It got a little small for me and that’s when I decided to leave, but no, I really enjoyed my time at Trout, incredibly grateful to the organisation for giving me the chance.
Evolution of Hedge Fund Industry Since 1970s (6:26)
Bilal Hafeez
And you mentioned your job was to allocate money to external managers, and in some ways you then had a front row seat on the evolution of the hedge fund industry over the course of the ’90s and later. What are some of the general observations you’d make about how hedge funds evolved as you’ve been assessing them and looking at them and investing them over the past few decades?
Sean McGould
I think when you really go back even further in history and look at when some of the hedge fund activities started, it would go all the way back to the merchant banks. Almost in mediaeval times where they were lending, there were trading commodities, they were doing all sorts of things and grew from there. Then you had the advent of some of the deregulation in investment banking that took over a lot of the proprietary trading and that coincided a little bit more with the birth of what I would call more of the mainstream hedge fund strategies. Back in 1993 when I got involved in the business, very different than what it is today.
You would have portfolio managers leaving probably very lucrative careers on Wall Street and investment banks, prop trading, other types of firms to go set up these entrepreneurial businesses, most of which had less than a hundred million dollars in capital. I remember the first managed accounts reports, so the MAR monthly newsletter that would come out on the hedge fund industry, and they would talk about the Hundred Million Dollar Club and it may have had 15 firms on it, and also the asset classes that were being traded then it was everything from fixed income mortgages, so you’re doing basis trading. It was CTAs, it was equity long short, but things were being done in a very different, and I’m not going to say I’m naive, they were actually cutting edge at that time because the data wasn’t available at that time. The computing power, believe it or not, wasn’t as available at that time. The risk systems were not as evolved as they are today.
So you went through a real period of time where I’ve been fortunate to have a front row seat to see how this has evolved. Happy to talk about some of the strategies that worked at one point in time that don’t work and the reasons for that, but I’ve seen throughout my career that regulatory changes and countries how they apply those regulatory changes can have a pretty dramatic impact on how hedge funds operate within the various markets.
Bilal Hafeez
Perhaps we can talk about some of the investment strategies. A very common one obviously is, especially amongst CTAs, is some momentum trend following strategy that in some ways forms the bedrock of many systematic traders and even discretionary traders, whether they admit it or not, in many ways they’re just following the trend. What were your thoughts on something like momentum and how that’s changed or the way people implement that? There’s been some mixed performance in the last 10 years one could say.
Sean McGould
Well, I think when you go back to the ’70s and ’80s, one of the big issues for systematic traders was just getting data. You would to either, you could buy daily high, low close data, but if you wanted to get more granular than that and get tick data, there were some tick data services, but you really had to collect it. Then the problem was, ‘Okay, I’m collecting all this data. Where do I store it?’ We take storage now for granted and then it’s, ‘Okay, how do I process this? What type of computer do I need? Do I hook several computers together to get computing power?’ So I think that some of the advantages that you have then have been a little bit eroded today. Computing power’s much faster, data’s more available, calculations on computers much faster. There was an edge back then I would say to momentum trading simply because people were a little bit slower to catch up to it. Now when you-
Bilal Hafeez
And just as a side note, I started off in ’97 at JP Morgan, and I remember, well, my earliest job was to go to the library of the LSC to photocopy pages of data and then my job was to input it into a Lotus 1-2-3 spreadsheet. Lotus 1-2-3 was a thing back then. It was a rival to Excel, and actually we were using Macs back then. It’s weird to think that in corporations Mac was still used as well as PCs, and then we’d use that to crunch data. When I think back, I think, ‘Wow, how times have changed.’
Sean McGould
But think of how valuable it was once you had that information it did provide an edge to what you were doing. I think nowadays with momentum, certainly momentum’s a factor in all markets and I think it is a common factor within a number of hedge fund strategies as well. I would say that it’s probably a little bit more episodic now than what it was back in the ’70s and ’80s. Also, you had a more inflationary environment in the ’70s when you had trend following strategies that were relying a little bit more on momentum. We haven’t really seen a highly inflationary strategy until last year and we’ll see how long it lasts, but in the ’70s it obviously lasted a long time. Commodity markets weren’t as well known. The other thing we should talk about is just transaction costs and access, so you only had a few FCMs that you could go to if they would accept you and the round ticket charges per lot were probably 35 to $50-
Bilal Hafeez
You mentioned FCM there. Just for the audience, if you can explain what FCM is.
Sean McGould
Oh, futures… So it’s a futures commission merchant. What it really is is a broker for commodities at that time, and you would place your trades through them, but you have to go through a process to be accepted. Trading per contract was very, very expensive. The trade transactions costs have come down materially now compared to where they were, but it was a very, very different time period, but I would say in some ways much less efficient than what you see today. Still the factors that existed then that have been well-documented by Barra and academic research, value, momentum, they still exist within the hedge fund marketplace today. I would say the two most common factors in most hedge fund strategies are a combination of value and momentum, because you want to buy something that’s either cheap and going up or you want to short something that’s expensive and going down and to me that’s the whole key to hedge funds.
Bilal Hafeez
I’d say something like value that everybody wants to have a value strategy, but it hasn’t performed well over the last 10 years. That’s been quite a puzzle in some ways and people have put up all sorts of reasons. They’re… one line of argument is that maybe we’re using the wrong metrics. Maybe there’s something around intangible assets we’re not capturing, or maybe there’s some other reason, low interest rates stopped value strategies from working. Do you have thoughts on that? Because this is a much debated area.
Sean McGould
I think I agree that some of the accounting is inaccurate. I think it’s very hard to properly account… to go from analogue businesses, which we had all the way kind of to the advent of the internet, to digital businesses which are now scalable much quicker across the globe. If you have a great idea now, there’s never a better time in history to scale that idea and take advantage of it and I think that’s important for businesses. I don’t think that accounting necessarily has caught up to some of the intangibles that are embedded in businesses that are more digitised and that have lower absolute types of fixed assets and things like that.
In the old days, if you looked at the advent of the railroad, well, you had all these physical assets and miles of tracks and railroad cars, locomotives, all of these things that were fixed assets that you could put your hand on and figure out how you’re converting those fixed assets into revenue and what you’re charging. A little bit harder today, I would say with some of the new business models and some of the more platform oriented business models that don’t rely as heavily on assets. You can look at a number of them, VBRO, things like that don’t really have assets, but they’re just digital marketplaces. I think it’s fascinating how it’s changed, but I think the classic definition of value has changed a little bit.
One country I would point to though, where I think there was a lot of value that’s now getting unlocked is in Japan. You did have traditional metrics of value there, land prices, carrying prices of equipment, all of those things, and now you’re seeing more of a focus in Japan of a little bit better corporate governance, a little bit more of rewarding shareholders. I think that’s why you’ve seen the Nikkei performed so well, particularly over the last year, is that some of that value is starting to get unlocked. That may be a case where it was really, really cheap, and again, there was a reason why it wasn’t being unlocked, but now it’s being discovered.
Getting Alpha From Shifts in Regulation (15:01)
Bilal Hafeez
And you mentioned earlier regulatory changes that impact strategies. What did you mean by that? You were talking about in Japan, these shifts in governance rules, or was there something else you were referring to?
Sean McGould
Well, a couple examples I can give in the US and then we can also shift to Japan. In the US, one of the first strategies that I thought was amazing, sharp ratios above two, all of those things was utilities pair trading. When you looked at the utility industry back in the early ’90s to late ’90s, it was all regulated. It was a homogenous group of securities, all in similar regulatory structures, different states. They could be powered by nuclear or gas or different things. They could be subject to different, basically capital rules, things like that, but if you were an expert in that area, you had a very good chance of picking which utility to go long and which utility to go short. The strategy worked very, very well, I would say for about a decade, but then started to lose its ability to produce consistent returns when you had the deregulation of the utility industry, so that really changed that strategy. Something that was stable and that worked very, very well, that shifted.
I would say the same thing in energy pairs trading with oil and gas, worked very well for a period of time when you had OPEC really controlling the price of oil. Then once you had fracking come into the picture and you had oil prices in a much wider range, and not that oil and natural gas aren’t volatile enough, but you really took out some of the underpinnings that I think it changed the global structure of the market and you had portfolio managers that had performed exceptionally well for a decade that suddenly really started to struggle. Again, this other type of change, and not necessarily regulatory in that case, but just a market-imposed change.
In Japan, you did have a time period where the Japanese government didn’t look as favourably on alternative investment firms, hedge funds operating within Japan that really pushed the market offshore. You had all these Japanese hedge funds working in Hawaii at the time and California and different time zones, but over the past five years, the regulatory conditions in Japan have changed and they’ve welcomed, certainly welcomed alternative asset management firms back. I think you’d also look at a big market like India where it’s incredibly difficult to short and we continue to look at a market like that as it opens up. Will that make some of these strategies easier to implement there? And then certainly China would’ve said 10, 15 years ago, really, really hard to short or run a head strategy and it’s become easier now over the last five years.
The Pros and Cons of Shorting Equities (17:34)
Bilal Hafeez
And you mentioned shorting that, in a finance theory perspective shorting is just part of efficient markets and there’s an ecosystem with shorts revealing information about the market, but obviously politically shorting has a stigma associated with it. What are your thoughts on shorting and the politics of it? Often when we had the global financial crisis, shorting was banned for a period of time and funds can be demonised somewhat for shorting. What do you say about that?
Sean McGould
Look, I think that short selling, one, I believe fully should be allowed. You should never be able to manipulate the markets and do that. I wouldn’t agree if someone’s trying to use that to do that, but there’s very legitimate reasons to short. When you look in a commodity market, people are allowed to short commodities and why are they doing that? They’re doing that for prices. When people shift over to equities they sit there and say, ‘Well, this is just speculation.’ Or they said that about credit default swaps and things like that, but there’s legitimate reasons to try and hedge your exposure to equities. When you look at some of the strategies that we run within fundamental equities and they tend to be more sector focused, it’s natural to want a short within the same sector that you are long and not necessarily saying that company is going to go out of business, but at the same time you’re making a relative performance decision that one company is going to outperform another, and that’s really the investment decision that you’re making.
So no, I feel that shorting is healthy for the market. It’s price discovery, and look, it’s treacherous. It’s not, the asymmetry of shorts as we saw in GameStop is really, really bad. You need to be careful on the short side, but I think it should absolutely exist because I think it helps with price discovery. I think it helps with market liquidity, and I would argue with any CEO out there who has a large short interest in their stock, if they can convert the short sellers into buyers or at least neutral on their stock, they’ve got a built-in base of people that have to go buy the stock back. Also in convertible bond structures, in secondary issues and all those things, the dealers need to be able to short securities to hedge. In the options markets you need to be able to short securities to hedge your exposure. To me it creates liquidity and creates just a more balanced market.
Hedge Funds – to Platform or Not? (19:58)
Bilal Hafeez
Yeah, no, I’d agree with that. I think short sellers in some ways are an easy target that allows companies or others to distract away from really poor fundamentals. Often in many cases, scandalous behaviours by corporates as well gets revealed through short sellers. Now I did want to ask you about Lighthouse. You founded Lighthouse Group a number of years ago. Could you talk a bit more about what you do at Lighthouse, what the focus is, and then we can delve a bit more deeply into some of the ways you manage risk?
Sean McGould
Sure, so started Lighthouse over 25 years ago. Now I left Trout trading in August of 1996 and actually moved to work with a group of families down in Florida that were interested in hedge funds at the time and built out portfolios for them of hedge funds, and mainly investing solely with external hedge funds at that time. In 2004, we really started to shift the focus of the business and create more of a platform. By a platform, I mean we really wanted to access portfolio management talent, whether it had its own fund vehicle, had its own operations, had its own risk systems, anything like that. We thought the most important ingredient was just talent.
If we could build a platform where we could trade all of these strategies on, it didn’t matter to us whether we were investing in an external fund or whether we were employing a portfolio manager or a team of people within our platform utilising our infrastructure. We started that process in 2004. It took us about five years to build that out, and in 2009 we had completed that. Then we started really launching our first hedge fund vehicle. Most of it is focused on US and European equities, but continuing to expand over into Asia. That now has over a 10-year track record and is run in a fairly neutral manner. That’s really one of the uses for the platform.
For us, building the firm was always about just the talent, and there are many groups around the world that are super talented what they do and want to be able to invest with them, but that’s really how we built up the firm and also built up the infrastructure around that as well, which some of our institutional clients like to use also. In total we manage about 15 billion dollars today, and that’s really been our brief journey.
Bilal Hafeez
And in terms of sharp ratios, again within the finance community and academic community, there was a debate about how do you measure risk and returns, sharps or tinos? Should you look at drawdowns? How do you think about what is the right way to measure performance more generally and philosophically?
Sean McGould
I think that it depends on if the underlying assets are liquid and fully tradable or if you have some illiquid assets in there as well. As an example, if you’re in a private credit strategy and you use sharp ratio, I’m not sure that’s a really good measure of risk. You’re taking credit risk, you’re accruing income every day. If nothing bad happens, you earn that. If you get repaid, you earn your return, but it’s not a really great example of the embedded risk. We tend to invest in very liquid instruments. Our turnover is fairly high. Our risk management depends on that turnover as well, so in our case where these instruments are freely traded, there’s volume in the instruments that we’re trading.
I do believe that looking at a sharp ratio or some volatility adjusted performance is a good way to look at it with one caveat, and the important caveat is, as we all know whenever you look at these markets they do not have normal distributions. They tend to have fat tails, they tend to have fat tails on the left side instead of the right side and you need to be mindful of that when you’re using any of these types of statistics. If you want to use something like modified VaR or you want to really shock things into different types of volatility at risk scenarios, I think that’s a better way to look at the absolute risk than just to say, ‘These returns are normally distributed, we can apply normal distribution. We’re all good.’
A good example of that lately would’ve been in March when you look at really two-year futures contracts around the globe. You had off the charts standard deviation move, so the big debate right now is is that the new distribution you should put into your risk models or do you use more data? Certainly we’ve seen it once, it can happen again. My argument would be probably not going to see that on that an extreme basis. It can happen, so that has to be in your scenario testing, but you need to understand that there are inherent limitations in any statistical measure.
Bilal Hafeez
Yeah, no, I’d agree with that as well. In terms of the strategies, are they systematic? Are they discretionary? Are they a mix? Philosophically, where do you stand on discretionary versus systematic?
Sean McGould
I love both because I’ve seen, in the early days back at Trout I saw systematic strategies work extremely well and have invested in systematic strategies throughout my career. I think that they’re tough and it’s a little bit of an arms race as far as the computing power, the talent, the transaction costs, the connectivity, all of those things to implement especially higher frequency types of systematic strategies I think are very difficult. I think what’ll be interesting is to see how there are a few groups I would say that have gotten machine learning right within the systematic space. It’ll be interesting to see how AI plays out in the future within that space, and I’m sure it will have an impact on it.
But also I’m a big believer in fundamental investing and can see that over many, many years that stock analysts, they’re actually very good at predicting earnings, at looking at the fates of companies, but not always earnings. You can have a different environment where stock prices don’t always track earnings over a short period of time. Over a longer period of time they should, but I believe in both types of strategies and we want to blend them really to create as smooth a return stream as we possibly can.
Bilal Hafeez
We’ve been doing a lot of work in machine learning and AI on trading strategies and what we found is there is some promise in it, especially when you use it on existing trading strategies, there’s a lot of interesting things you can do. I think it holds a lot of promise, I think, so I’m quite optimistic on that side.
Sean McGould
I think if you had truly unique data sets to apply some of the technology to, I think that there’s a lot of things that can be done, but I’m sure you’ve also seen that over time some of the machine learning in the early days was really what I would call more curve fitting and it’s a little bit problematic if you’re just searching for a solution rather than trying to determine a probability of outcomes that are reasonable and somewhat sustainable. Seeing certainly a number of mistakes made in the area, and I’m sure some mistakes that we made with AI as well, but no, I’m excited to see what the technology can do.
Bilal Hafeez
Now in terms of platforms, the way you’ve constructed your platform is a bit different to how many people would think of a platform fund, hedge fund where they think of Millennium or these platforms where you have the overall company, then PMs join, they have a pod, they use the platform, hedge funds infrastructure, and then they trade it in that way. You seem to have a hybrid type system. I’m not sure if that’s the right word to use, so you have the pod system it sounds like.
Sean McGould
Yeah.
Bilal Hafeez
But then also you have an allocation to external managers who you somehow integrate into the system and you almost have an agnostic approach to whether they’re internal, external. Is that a fair characterization?
Sean McGould
That is correct. If our portfolio managers, if they would prefer to set up their own management company, we can do that. If they prefer to be employees, we’re flexible in that. Again, it really goes back to the background that I had when I started in this business and the partners that I have in this business that we work within a hedge fund, and yet we had external portfolio managers managing a portion of it as well. It was a fairly unique setup at the time, but it’s worked for us. We’ve developed a lot of relationships across the industry and I think it’s great that we can harness talent in a number of different ways, and that’s how we’ve chosen to set up our particular platform.
How to Pick a Portfolio Manager (28:15)
Bilal Hafeez
Now you’ve worked with lots of external managers, so I have to ask you this and I’m sure there’s no single answer, but how do you pick a good manager, whether it’s internal, external? How do you know if a PM will be good or not?
Sean McGould
Well, the honest answer is you don’t necessarily know, and like we talked about before, there’s some market factors that can change. You can have a fantastic PM and then the market changes, so the first thing that we have to look for, and again, besides the obvious things of character integrity, those things go without saying, but someone has to be able to articulate an investment strategy to us. Someone has had to have thought about what they’re trying to accomplish, what the goals are, what the objectives are, what they believe their advantage is, and what I believe is otherwise a fairly efficient marketplace. You really have to have an understanding of how they’re set up and what they’re trying to achieve through their investment process.
The next most important thing for us is that there is a risk management process in place as well, so if you’re losing money, what are you going to do? Are you going to double down? Are you going to cut risks? We were definitely trained more in the philosophy, and that’s certainly my philosophy, when things are going against you get smaller, when they’re working for you, you can get a little bit bigger, but not necessarily trying to fight the market in that regard. Everyone has their own unique way of looking at risk and they need to be able to articulate what they’re going to do in difficult situations or if they’re wrong, how they’re going to get into and out of positions. Those sorts of things are very, very important as well.
And the last thing would be experience. We really don’t have the ability necessarily to just train people purely. If someone brings us a completely new idea and they don’t have any experience in the markets or implementing that, so they don’t have any experience with transaction costs, they don’t have experience with trading, those sorts of things, it’s probably not the right fit for us. Some experience of trading the strategies, we tend to work with very experienced portfolio managers because I think you need to have taken some losses, you need to refine your risk management approaches over time and have a real risk philosophy. You need to have been through some different market cycles. All of those things are very, very important, but yet you have to have an investment process and describe the edge. You have to be able to articulate a risk management philosophy and you have to have experience.
Bilal Hafeez
And on the experience side, historically you touched on this, investment banks had prop desks and prop desks were a big supplier of portfolio managers into the hedge fund industry. Now since we had the Volcker Rule and since global financial crisis, most banks have had to shut down their prop desks. Do you find there’s an issue in terms of the talent pool coming to hedge funds that there isn’t a training ground for new talent?
Sean McGould
Well, I think that in some respects the talent has changed more towards the hedge fund industry, which has grown massively from a few hundred funds back in the early ’90s to three or 4,000 today just in the US and probably that many in China as well. I think that there’s more training possibilities within other hedge funds. Also within traditional asset management firms, they’ve started some programmes with hedge fund investing and doing things both systematically and fundamentally as well, so I think that there is a large pool that’s out there.
It’s definitely competitive as far as the talent space and some of the talent that came off of the investment banks as well had a big advantage that you don’t have in the hedge fund space, which was some of the flow trading and some of the information that they would’ve seen. Again, going back to the ’90s, the rules have all changed, it’s very different now, but you could have taken someone off of the prep desks or flow desks and they would’ve really struggled within the hedge fund space. You had to be careful as to what the training arm and what people’s backgrounds are and what they relied on to generate the returns that they did or the representing that they did as well.
Bilal Hafeez
And in terms of the macro regime today, we have high inflation, high interest rates. It does feel like we’re entering a new regime, which is quite different to the post-GFC period of low rates. Even before that, a low inflation environment pretty much since the mid ’80s you could say. Do you think that means that you as an investor or just investors in general need to shift their approach to investing?
Sean McGould
I think there will be more opportunities this decade for hedge funds if we normalise interest rates. I think we hadn’t seen a period of time like we saw from the GFC through the COVID time period where rates were kept that low and really, really constrained. There’s fiscal repression, certainly interest rate repression, and I think when you allow that to normalise, you’ll break back some more normal levels of volatility in the marketplace, which I think are very, very healthy.
I think that normal level of volatility also relieves some of the stress that can really build up and in the markets over time. We saw examples of that this year where we had a string of bank failures obviously in the US in March that happened very quickly all through rapid rise in interest rates and deposits being taken out. I think the more you can diffuse risk across the system and let it blow off a little bit over periods of time, it’s much better than having catastrophic risk events. As we’ve seen in the past ’08, we saw banking, we’ve seen banking crisis forever, going back to the 1800s as well. I think allowing the system to function, allowing entities to fail, having a little bit more variability in the markets, I think is a healthy thing and I think that helps with the returns as well. There’s a little bit more of a risk premium put back in the markets.
I would say one phenomenon right now that might be suppressing some of the equity volatility in the market is just the advent of options trading and just the amount of gamma exposure that we had. We had a big options expiration last Friday, and you can see where the market’s going to be pinned in terms of some of the options trading. I’ve really been fascinated by looking at that over the past couple years to see how that technical is starting to influence some of the volatility in the market, but I think on Friday the fixed closed right around 14, which I believe would certainly be the low for the year, but it was on that options expiration.
I think these dates in September, December, I think they’re becoming more important, but the buildup technically in the markets is also really critical to understand and watch if you’re trading in a shorter term timeframe. If your investment horizon is years I don’t think it matters as much, but I think it’s something that we need to pay attention to.
Understanding Options Strategies (34:36)
Bilal Hafeez
Can one build an investment strategy, do you think around these short-term dynamics?
Sean McGould
I think you can, and I think there are people that are starting to, I think some of the machine learning approaches may have already started to pick up on some of the things that are happening around. I would say a lot of it’s around the weekly and daily options that are more common in the US and that can fade as well, because the best thing to do this year has to just been to sell short-term options and collect your money every week and just roll them, but I think we’ve seen that with the VIX a few years ago where everyone was selling down the curve of the VIX and it blew up in about a week’s time. I don’t think this will end well and that will probably change the market dynamic again, but yes, I think there are some ways to take advantage of that. Also if you have a belief that more volatility is in store over the next six to 12 months, I think it’s an incredibly good time to have some hedges on just because the implied volatilities are fairly cheap.
Bilal Hafeez
And another dynamic that may or may not change we’ll see is the rise of private markets, especially since the global financial crisis, private equities become huge, VC, private credit and so on. One is obviously, is that an area of alpha for you? And the other question is, has that crowded out public markets? So there’s less opportunity for you in terms of just the universe of instruments that you can trade?
Sean McGould
I think when you look at the rise of private credit and just going back to Dodd-Frank and Volcker Rule that has changed the landscape of hedge fund investing. I would say we are less involved in the private markets, but I think it’s a great opportunity because again, you’ve had a regulatory change where banks have had to come out and you’re seeing alternative investment firms fill that. I think the other interesting thing is in the US you are seeing private companies and the equity of those private companies stay private for longer. You have seen a drop since 2000 of the number of listed equities in the United States, but if you compare that to the number of listed equities in China, it’s actually risen. You have all these ebbs and flows around the world, and that’s why it’s very important for us to have it set up. Our platform has to be global to take advantage of these changes.
I think the change in the Volcker Rule made it a little bit easier for hedge funds because prior in 2007, if you looked at merger spreads, they were dominated by investment banks, they had the lowest cost of capital, they had the ability to trade those spreads, they could leverage up their balance sheets. Well that source of competition and those spreads is gone. You really do have to watch these changes and see how they’re happening. I think it’s great. I think again, it diffuses risk as we spoke about a few minutes ago across a broader platform of investors, which is generally good for the markets. I really don’t think anyone has an unfair cost of capital advantage as I think the investment banks did. From ’04 to ’07 they just had a lower cost of capital and could really pile into these strategies at a much tighter spread and make a return on equity that worked for them. I think this will continue to evolve, but I think there’s always opportunities that come up from these changes.
Trends Over the Next 5-10 Years (37:50)
Bilal Hafeez
And in terms of when you look through your crystal ball to the outlook in terms of trends for the industry in the next five to 10 years, what are some of the things you see? One of the contextual points I just want to add was we’ve obviously seen a massive rise in ETFs and passive investing in the last 10, 15 years. Do you think there’ll be a shift towards active and then within active, what types of strategies you think will stand out? And just something general about where you think we’re going as an industry?
Sean McGould
I think that you’re starting to see less and less equity research published on some smaller companies. I’m not saying micro-cap companies, but I’m saying some companies that used to be fairly large, that are very limited research coverage, multi-billion dollar companies that just have less coverage and that’s on a global basis. Someone has to step in and fill that void and I think that hedge funds can do that particularly well, so I think you’re going to continue to see a dearth of coverage because the investment banks, I think their incentive is again, they want large IPOs, large transactions, those sorts of things. I think the cost of companies being public will continue to remain fairly high. Unless you break down some of the regulatory costs and other things that are necessary, I think that fewer companies may choose a public route until they’re of a certain size going forward.
I think when you look at a market, if the government sponsored entities really want to get out of that market, it’s going to mean that more private capital is going to have to flow in there. It’ll create more volatility. Again, that’s something that can be taken advantage of, but I think these regulatory themes will continue to drive that. I think also you will start to see the ability of more crowdsourcing of ideas. There’s a few platforms that have been developed just to go do that, to take talent globally, no matter where it is, to provide data sets to really talented either computer scientists or other individuals that have ideas on how the market works and you can harness their ability as well.
And then also I think it will become easier just to clear and settle trades. Going forward I think there’ll be a more unified approach, and whether that’s through the blockchain or other technologies that are developed, it’s really funny that we sit here today and you have so many disparate systems and things that need to talk to each other. I think that you’ll see that more homogenised going forward, which will make it easier for people to get involved in the market, which again, I think is a good thing. No, I’m optimistic about the strategies that can be implemented within hedge funds and especially across the globe and especially as you open up additional markets for trading.
Bilal Hafeez
And in terms of your outlook in say, the next six to 12 months, do you have a macro stance? Are there certain strategies you think will do particularly well? And you mentioned earlier you think it’s given the level of equity vol, it may be useful to use low level of vol to hedge yourself against an equity correction. That’s something you’re thinking about. What things are you thinking about?
Sean McGould
I think when we look at certain strategies, we bucket them into more evergreen strategies and then things that are more opportunistic. We believe that the alpha approach we have in the equity markets, which again it tends to be more fundamentally based and sector focus. We think that works well in the majority of environments, certainly can go flat for a period of time, but the equity markets, there’s always changes in terms of company performance, in terms of earnings, in terms of product releases, consumer preferences, consumer travel behaviour, all of those things, energy usage. There’s always going to be things going on within the equity market space that we believe managers can take advantage of.
Same thing within the macro space it’s changing, so are we going from an inflationary regime to lower inflation? Are interest rates a buy here? Have we capped the interest rate process within the US and within Europe? I think those changes, again, are there to be taken advantage of and we’ll position ourselves to do that over the next, I would say three to six months. I would say other strategies are a little bit more opportunistic, so we haven’t seen a huge credit cycle. Our credit allocation right now is some of the lowest that we’ve had in the firm’s history. We’re being patient there to see what unfolds, but if something does unfold, then we want to take advantage of that.
The Best Investment Advice (42:07)
Bilal Hafeez
Now, I did want to ask some personal questions as well to round off our conversation. One is, what’s the best investment advice you’ve ever received from anyone over the course of your career?
Sean McGould
Oh, I would say the best investment advice would be probably to cut the losses. I’ve never had a problem doing that. I think it’s a skill that people need to learn. You can always step back and reassess, especially when your strategy revolves in turning the portfolio over every quarter to six months. When you think about that, it’s foolish just to hang onto a position. You can always reenter it, you can always reassess it. I think that’s been really important to understand that you are not, wish we could make money every single day. That’s probably not going to happen, but you really need to be disciplined in your risk process and just admit when you’re wrong and follow your investment process. Learning that from a very early age has been very, very helpful.
Bilal Hafeez
And some of our audience are relatively young, they’re leaving university or will leave university after the summer to enter the real world in the work world. What advice would you give youngsters as they enter the work world?
Sean McGould
I would say the biggest thing is that if this area interests you, you need to have a lot of intellectual curiosity. There’s tonnes you can read on the finance base and learn. I would say the other important thing is to reach out to people within the industry and talk to them about their experiences, so if there’s something you’re interested in, reach out to someone that’s doing that. I think you have a real advantage from the time you’re probably 15 to through university I found that people are very willing to give their time to talk to students and younger people that are interested in this space, and certainly I’ve always enjoyed doing that and talking to people about what we’ve done at Lighthouse and what we’re trying to do, but you need to reach out and be proactive, and if you do that I think you’ll find some people with a lot of experience will open up and have a conversation and give advice there.
I would also say reading. I learned a lot through reading and I had to do that very quickly when I joined Trout. One of the things that really, really helped me was in the early days I would listen to a portfolio manager. If I didn’t understand exactly what they were saying I would go to books, read what the strategy was, and then I would write up their strategy and give it to them and have them critique it. If I got it right through writing it and they agreed with what I had written down on that piece of paper saying, ‘This is your strategy, did I hear this correctly?’ I learned a lot. I also found by having to articulate that and write it down, that it helped quite a bit.
Bilal Hafeez
That’s a great thing to have done actually. I think you’re the only person I’ve heard ever do that. That’s great.
Sean McGould
I don’t have as much time to do it now as I would like, but it’s really how I learned certain types of strategies like convertible bond investing, fixed income investing within mortgages, things like that. It really, really helped. If you can write it down and on one piece of paper and explain it to someone, I think you just understand it better.
Books (45:01)
Bilal Hafeez
No, that makes sense. You mentioned reading a lot there, so what are some of the books that influenced you?
Sean McGould
I would say when I was thinking about this a little bit, three books that really in the market that I think are really important, especially for me, your younger listeners or people just started in the industry. I think one of the most important things to understand in the marketplace, and again, this is more from a little bit of a shorter term investment perspective, but you have to understand options, and whether you trade them or that I just think understanding probabilities through options is the most important thing and I think the classic book on that was written by Sheldon Natenberg, which is Option Volatility and Pricing. It’s a little bit older, but I think it gets through the concepts. If you can understand distributions of financial prices and the probabilities of hitting those prices, you can understand a lot about how the financial markets work, so I’d say that that’s one book to read.
I would say that whole series of books is fantastic to read about different types of trading strategies, investment approaches. It really covers the gamut. It can cover equity investing in the newer books, it covers trading strategies in the older books, it still applies. Just reading those interviews and understanding is really important. Then if you’re specifically interested in hedge funds in the history of hedge funds, I would say More Money Than God, which was written by Sebastian Mallaby, I believe just goes through a great history of hedge funds and a little bit more of a modern timeframe to it, but those three books, I would say, in the case of the Market Wizards series of books, I’d say just reading those three would give you a great background for financial markets and hedge fund investing.
I would also say one other area that I get a lot more information is through podcasts, and your podcast is great, but the beauty of podcasts is that the information is current. When you go to a book, it’s not as current, and now by building podcasts and certainly you’re up to, what the 170 episodes practically now?
Bilal Hafeez
Yeah, that’s right. Yeah.
Sean McGould
It’s just fantastic as far as the amount of information that’s out there and the timeliness of it and the guests and everything, so congratulations on what you’ve done here. I think it is, I find myself was a ferocious reader, but podcasts didn’t exist until a few years ago. I find myself listening more and more to podcasts and searching for different points of view, especially from different people, so thank you for doing this and putting this together.
Bilal Hafeez
Yeah, no, no. I’m a big fan of podcasts as well. That’s part of the reason why I wanted to do this as well. I agree. I used to read a huge amount in my younger days, but now podcasts have filled the gaps in some ways. You say it’s very current. If a new technology comes out, there’s a macro event happening, you can get some quite thoughtful insights by listening to a podcast.
Sean McGould
Yes. Very, very quickly. I think that’s also a great way to get up to speed quickly for some of the younger listeners or just people starting out in the industry. Go search the web, listen to this podcast. Absolutely. You’re going to learn a lot just by going through all these episodes. It would take you quite a while, but if you went through them, you’d have a great history of the last few years of what’s going on and in the macro space.
Bilal Hafeez
Yeah, no, that’s great. With that, Sean, thanks a lot. It was excellent learning from you and good luck with the company and investing.
Sean McGould
Thank you very much. Appreciate you having me on, and good luck going forward as well.