Commodities Corporation: Traders, Innovators, and Making a Virtue out of Necessity
"I have known many great traders and 99% of the time, the market is bigger than anybody. It goes where it wants to go. There are exceptions, but they don’t last too long." Michael Marcus
A couple of weeks ago, I had a chance to interview Michael Mauboussin (the full conversation will be available at Compound soon). I asked him about his tweets about Druckenmiller and he out the paradox of position sizing:
“Here we have George Soros and Stanley Druckenmiller, two legendary investors who say that this is the main thing that drives their returns and results over a long period of time. Whereas we look at the real world, we find that most people don't create a lot of value from sizing and it's all security selection. The question is can we bring those things together to some degree?”
His comment hit on a broader point: it’s easy to ascribe the most value to tasks that receive the most attention or seem the most interesting. Many books have been written about how Buffett picks stocks. But what is more interesting is how he created conditions of longevity when he discarded the hedge fund structure in favor of Berkshire Hathaway’s permanent capital or how he evolved as an investor by cultivating new friends or mentors. There is too much focus on specific actions (in his case investments) compared to the design choices he made in business and life.
Similarly, a book outlining some of Renaissance Technologies' mysterious algorithms might sell very well even though their publication would presumably render them useless. After learning about Jim Simons’s five principles, I dipped back into his biography, The Man Who Solved the Market. I was struck by how much his success was based on creating conditions that ultimately led to success. Simons courted talent and provided space and encouragement to test and refine their ideas. While he kept building the system behind Renaissance, individual researchers and traders churned. “I’m doing all the trading, and he’s just dealing with the investors,” one early partner complained in a classic case of misunderstanding what was driving long-term value.
When one of his researchers became obsessed with collecting more granular historical pricing data, Simons was happy to indulge this curiosity even though it was effectively R&D without a clearly defined payoff. It was an investment in building a system rather than an individual strategy.
“Straus and his colleagues created and discovered additional historical pricing data, helping Ax develop new predictive models relying on Carmona’s suggestions. Some of the weekly stock-trading data they’d later find went back as far as the 1800s, reliable information almost no one else had access to. At the time, the team couldn’t do much with the data, but the ability to search history to see how markets reacted to unusual events would later help Simons’s team build models to profit from market collapses and other unexpected events, helping the firm trounce markets during those periods.” The Man Who Solved the Market
Simons created a campus for the best quants he could find. This reflected his second principle: “Surround yourself with the smartest and best people you possibly can. Let them do their thing. Don’t sit on top of them. If they’re smarter than you, all the better.”
He wasn’t the first to build a firm around quantitative research with a culture modeled to be distinct from mainstream Wall Street. In 1969, a kind of proto-Renaissance Technologies opened in Princeton, NJ.
Helmut Weymar wrote his PhD dissertation at MIT about a method for anticipating the price of cocoa based on an analysis of fundamental data affecting supply and demand (such as economic growth and weather conditions). After a stint at food conglomerate Nabisco, where he traded cocoa based on his model, he left to set up his own firm: Commodities Corporation.
Weymar assembled a group of specialists in different commodities. He believed the combination of sector expertise, deep fundamental research, and use of new computer technology would provide the firm with an edge. Like in the early days of Renaissance, computers were not yet advanced enough for complex and fully-automated trading systems. They existed to support human traders.
In its brochure the firm described its objective as profiting “from an understanding of the relatively stable but complex relationship of prices to supply and demand factors” through “specialized intelligence gathering” (e.g. the firm hired people who traveled emerging markets surveying conditions on the ground) and “the use of computers and econometric analysis.”
It was an auspicious time to start a commodities-focused firm, right at the beginning of a new bull market.
However, just like Simons the firm had to find a balance between a drive for innovation and a study of history, including the lessons learned by every generation of traders.
“Simons was a mathematician with a limited understanding of the history of investing, however. He didn’t realize his approach wasn’t as original as he believed. Simons also wasn’t aware of how many traders had crashed and burned using similar methods. Some traders employing similar tactics even had substantial head starts on him.” The Man Who Solved the Market
Simons had to change gears multiple times and learned about risk management the hard way: through drawdowns. When the trend-following strategies of the 80s stopped working, he had to re-architect his portfolio. He shut down a long-term partner, limited longer-term trades, the source of their losses, and simultaneously convinced investors of the prospect of “new and improved tactics.”
“Their fund had been losing money for months and was now down nearly 30 percent from the middle of the previous year, a staggering blow.” The Man Who Solved the Market
Simons was the architect of a system. The firm’s long-term prospects and survival were more important than any particular trade, trader, or strategy.
Corn Blight Again?; Farmers Fear 1971 Attack Could Be Disaster, New York Times, 1971
Weymar had to learn a similar lesson at his fledgling fund. In 1970, corn was being devastated by a fungal disease called the blight. The market expected a repeat in 1971 driving up the price of corn. Weymar and his partners hired a scientist who investigated the blight and conditions on the ground. The consultant concluded that the “blight fright was overdone.” Shorting corn seemed like a sure winner and Weymar took a massive position.
Soon after, CBS News ran a prime-time report with its own expert who flat out contradicted Weymar’s scientist.
“They had built a vast short position in the corn market, betting their firm on the advice of a pathologist who was now being contradicted by a senior colleague. When the markets finally opened on Monday, corn futures jumped so steeply that trading was immediately suspended.” More Money Than God
It took Commodities Corp.’s traders another day to cover the short. By then the firm’s initial capital base of $2.5 million had shrunk to $900,000. It was a new firm without a track record. A drawdown of 64% should have been fatal.
Several of the founding partners wanted to withdraw their capital. Four of the seven founders left. Weymar worked out a deal with the firm’s board: the firm would be closed if it lost another $100,000.
“He had begun with an economist’s faith in model building and data: Prices reflected the fundamental forces of supply and demand, so if you could anticipate those things you were on your way to riches. But experience had taught him some humility.” More Money Than God
In a bitter irony, the firm’s research consultant turned out to be right. The blight did not return in force and the price of corn fell. But the firm had already been forced to close out its short at the top of the market. Overconfidence had nearly put it out of business.
Weymar later reflected on the experience which led the firm to adopt different risk management and trading practices.
“It was important for Commodities Corp. to have this horrible experience. The most dangerous traders are the ones who have gotten big without getting creamed.” Helmut Weymar
Over time the firm turned into a fund of funds, seeding prominent managers including Paul Tudor Jones and Louis Bacon of Moore Capital. Sebastian Mallaby wrote that Bacon was “too independent” and Jones “turned down a job offer” but both happily took seed money for their funds and “would arrive by helicopter from Manhattan to attend traders’ dinners in Princeton.” Another notable alumnus was Bruce Kovner who left to found Caxton Associates.
By 1997, Commodities Corp. was acquired by Goldman Sachs which was looking to build out its asset management and hedge fund of funds business. Amazingly, Commodities Corp. had turned its near-death experience into a strength:
“Commodities Corp.'s excellent record of risk management over three decades should be a strong selling point at a time when steep losses and ugly scandals have hit such big hedge fund groups as convertible arbitrage specialist Lipper & Co. and mortgage-backed securities operation Beacon Hill Asset Management.” Institutional Investor
When the books were closed out with the acquisition, Institutional Investor noted the firm’s “glittering” track record of “compounded annual returns of 24% over 27 years.”
“Anyone who had invested $10,000 with Commodities Corp. on day one and let it sit for 27 years would be worth $3.35 million today.”
Lessons from Princeton’s trading campus
First off, a shout out to the team at Macro Ops who have published excellent trading lessons from Commodities Corp. and its traders. It’s not an area that I will focus on. Needless to say, markets have changed a lot since the 1970s. While the principles and general ideas may still apply, the methods would have to be overhauled to fit a new context.
For example, in his Market Wizards interview Kovner talked about the signal value of a move in price on no news:
“The market usually leads because there are people who know more than you do.”
But his specific application was in currencies and grain markets because that’s where the Soviet Union (“a very good trader”) was active (through intermediaries). The idea of whale traders creating valuable signals may still apply in some markets. But the specifics are not more than an interesting anecdote (who knows, maybe some trader out there has a way of tracking the Chinese impact on certain commodities?).
I’ve collected more key lessons below (paywalled):
Confidence bordering on arrogance
A better system: computers and timeless trading aphorisms (Amos Hostetter)
Automated trading, the holy grail?
“The upper echelon of successful traders requires an innate skill, a gift.”
Recruiting talented outsiders
The pragmatists take over
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Confidence bordering on arrogance
This may seem trivial but a quote by Kovner reminded me that for this story to have happened, Weymar first had to believe that it was possible to beat the market. He had to have a confidence bordering on arrogance that allowed him to leave a comfortable corporate job and set up his own trading and research operation. He needed conviction to tell a story and raise capital.
“I thought random walk was bullshit. The whole idea that an individual can’t make serious money with a competitive edge over the rest of the market is wacko.” Helmut Weymar
In Market Wizards, Bruce Kovner talked about how being mentored by Michael Marcus gave him the confidence to believe in the possibility of winning in markets:
“He taught me that you could make a million dollars. He showed me that if you applied yourself, great things could happen. It is very easy to miss the point that you really can do it. He showed me that if you take a position and use discipline, you can actually make it.”
Whatever domain you choose, if you aim high you will need to believe that success is possible for you. You will need a lot of self confidence and this confidence may seem irrational to others. In an ideal world you have a deep inner well from which to draw. But it’s not like that for many people. Certainly it hasn’t been for me. Finding people who believe in you, who show you what is possible, and who can fill your well of confidence can be invaluable.
A better system: computers and timeless trading aphorisms (Amos Hostetter)
Fixing the firm’s risk management seems to have rested on a two-pronged approach. First, it needed a change in philosophy. One of Weymar’s partners was an old-timer, a trader named Amos Hostetter Sr. born in 1902. Hostetter may have been an embodiment of the saying that there are old traders and bold traders - but no old and bold traders. When cutting a loss he liked to quip:
“Never mind the cheese. Let me out of the trap.”
Having doubtlessly seen countless traders and firms flame out, Hostetter offered a valuable balance to Weymar’s youthful confidence (“a colleague once suggested that putting Weymar in charge of risk controls was like putting Evel Knievel in charge of road safety”).
When Hostetter died in a car accident in 1977, Commodities Corp published a little booklet containing his trading principles: Amos Hostetter: A Successful Speculator’s Approach to Commodities Trading by Morris Markovitz (find notes at Macro Ops). It’s an interesting time capsule with basic principles for any discretionary trader:
Try to acquire every bit of fundamental information available. Read extensively.
Simultaneously, post daily charts on commodities and develop a feel for trends.
Follow the fundamentals in your trading but only if and as long as the charts do not cast a negative vote.
Other key principles revolved around risk and money management:
A very general and important rule is: take care of your losses and your profits will take care of themselves. This is both a trading maxim and a money management tool. A trader needs big winners to pay for his losses, and he won't capture these big wins unless he stays with the trend all the way.
There is never any objection to taking a loss. There must always be a good reason before you can permit yourself to close out a profit.
When in doubt, get out. Don't gamble. Be sure, however, that your doubt is based on something real (fundamentals, market action, etc.), and not simply on your own nervousness about the price level. If it is only the price level that is making you nervous, then either stick with the winner or, at worst, use a more sensitive stop-loss point. Give the major trend all the chance you can to increase your profits.
While a trader of Hostetter’s generation had to have the discipline to implement these rules, Commodities Corp. could build a system to enforce them automatically.
Mallaby explained how the firm adopted the “segment-manager system” from hedge fund pioneer A. W. Jones:
“Each trader was treated as an independent profit center and was allocated a pot of capital whose size reflected previous performance.”
“The upshot was a risk-control system that survives, more or less, in the contemporary hedge funds whose origins are entwined with Commodities Corporation.”
Commodities Corp. became an early iteration of a pod shop or multi-strategy hedge fund. And because it dealt in futures contracts and its traders could use high leverage, the firm implemented strict risk controls:
“The new Commodities Corporation system capped the risk that a trader could take in any one position; and if a trader racked up big losses, more controls kicked in.”
“Anyone who blew half of his initial capital had to sell all his positions and take a month off.”
These rules protected capital but they also protected the traders. I found this interesting quote in a commentary on Michael Marcus’s trading principles:
“Trading has two types of capital that must be managed – financial capital and mental capital. In this case, losing a lot or being unsure of your system drains you of your mental capital.”
Traders who lost significant amounts of money were removed from their seats before they could implode, melt down, or go on tilt in a desperate effort to claw their way back.
Distance and space for recovery had to be forced to do it. Remember Druckenmiller’s sabbatical in 2000 and Dan McMurtrie’s conversation on resilience. There are moments when one’s inclination is to double down and push harder to make it all back. Those can be moments when your mental capital is depleted and your decision-making impaired.
Paul Tudor Jones adopted this principle in his own risk guidelines:
“These guidelines are designed to keep traders from hurting themselves.
Just as Michael Jordan needs a coach … so too does every trader need someone to help them in times of severe stress.”
I think we can extend this concept to anyone who has to deal with severe and sustained stress while making important judgments.
Automated trading, the holy grail?
Sebastian Mallaby wrote that the firm’s original risk-control system was too complex and impractical. Traders could freely pull from a shared pool of capital and were being charged an escalating cost of capital depending on position size and volatility. However, high cost didn’t deter the traders’ egos and clerical staff was behind in tracking exposure. Which meant that effectively “there was no risk control of any nature.”
The company developed a new “Technical Computer System” (TCS), one of the early automated trading systems.
“The great virtue of an automated trading system was that risk controls had to be programmed into the computer from the start, and there was no danger of overconfident traders exceeding their allowed limits. But the TCS had proved itself to be superior at calling the market too.”
Simons at Renaissance also saw the value in building trading systems to take the behavioral element out of the equation. However, he long battled his own trading instincts:
“Jim believed the fund should be managed systematically, but he was fussing around when he had time, five to ten hours a week, trading gold or copper, thinking he was learning something,” Berlekamp says.
Others at Renaissance saw the value of removing the emotional human trader:
“Our P&L isn’t an input,” Patterson says, using trading lingo for profits and losses. “We’re mediocre traders, but our system never has rows with its girlfriends—that’s the kind of thing that causes patterns in markets.”
The dotcom bust was a great example of the tension between human and model at Renaissance. The trading system was designed to “learn” and emphasize signals that had worked well. When the bubble was inflating, short-term trend following in equities worked very well and the model started to weigh those more heavily. Once the bubble collapsed and Renaissance started losing money, Simons told his colleagues to “trust the model. We have to let it ride; we can’t panic.”
But once the team figured out the momentum strategy was losing money, and with losses being quite severe, Simons dumped the signal. He told one of his colleagues that they had learned a valuable lesson to “never to put your full faith in a model.”
“The upper echelon of successful traders requires an innate skill, a gift.”
Michael Marcus pointed out another recurring lesson: the difference between a great analyst or researcher (like Weymar) and a great trader or risk taker.
“Helmut was an incredible expert on cocoa. He wrote a book that was so deep I couldn’t understand the cover. Also, he had all kinds of friends in the business. With the knowledge and information I got from Helmut and his friends, I felt that I knew the universe of cocoa in a way that I had never known any market before.
Let’s just say that I traded much better on Helmut’s information than he did.
I think to be in the upper echelon of successful traders requires an innate skill, a gift. It’s just like being a great violinist. But to be a competent trader and make money is a skill you can learn.” Michael Marcus, Market Wizards
While he called it a gift he was also honest about its limitations:
“I feel like trading is the only thing I am really good at. If not for that, I probably would have wound up shining shoes.”
Recruiting talented outsiders
Weymar was intent on building a campus of specialists who created an edge through deep fundamental research in their respective markets. Commodities Corp. ended up being something different, a breeding ground for flexible global macro traders who shared trading principles but rotated between different asset classes and balanced fundamentals with technicals.
The firm had a dedicated recruitment system, called the Trader Evaluation Program (TEP). Weymar had a preference for hiring people with strong academic pedigree. But if the ability to trade was at least somewhat innate, as Marcus pointed out, then traders had to be tested before they were hired. Prospects were given small amounts of capital (Kovner for example was given $35,000 to trade to start):
"If someone looked promising, we would give them $30,000. Then if they delivered really good performance, we would give them 50." M. Roch Hillenbrand
Like Renaissance, Weymar wanted his firm to be different from Wall Street. The office was in a farmhouse “surrounded by flowering trees and acres of lawn.” Employees showed up in khakis and polo shirts. One of Weymar’s partners brought his dog, Peanuts. Things that may seem normal today but were unusual in the 1970s.
“The informal atmosphere signaled the firm’s distance from the hustle of New York: Commodities Corporation was not about salesmanship and relationships and looking like a market insider; it was about beating the market with computer models, math, and superior information. The founders exchanged trading theories at regular seminars, filling a blackboard with formulas. It was a long way from the stock-jockey ethos at A. W. Jones or from the pizza-strewn chaos of Michael Steinhardt’s trading room.” More Money Than God
Commodities Corp. has been described as “a trading university” and mentorship and a collaborative exchange of ideas seemed like important factors. One trader attributed the firm’s success to “the sharing of those trading philosophies and the money management skills that were passed down by the founders and first generation.”
Two of its most famous traders, Michael Marcus and Bruce Kovner, were academics with a passion for markets. Marcus dropped out of a PhD program in psychology. Kovner had also pursued a PhD. It seems to me they were selected for qualities such as curiosity, open-mindedness, a passion for markets, raw intellectual horsepower, and mental fortitude.
“Marcus… studied the economic fundamentals that might drive markets. He would arrive in the office each morning with an oversized briefcase packed full of market reports; there were no Post-its back then, but Marcus used sticky tape to attach careful handwritten notes to key pages from his reading.” More Money Than God
Kovner worked as a writer, on political campaigns, drove a cab, and studied music. In his spare time he “studied the futures markets, borrowed $3,000 against a MasterCard, and turned it into $22,000.”
“Kovner had read more than they had, starting with historical classics such as Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds and extending to contemporary newsletters. “I really value richness in intellect, and Bruce was rich up the kazoo,” Weymar recalls.
Michael Marcus, who had once studied psychology, noticed something about Kovner early on: He had a physical and psychological strength that set him apart from his colleagues. Kovner knew how to let go of distractions; he did not overthink his trades and had no trouble sleeping. Other traders might make money faster, but they would lose it faster too; Kovner was consistent, and he had a sort of nerveless temperament.” More Money Than God
“A good trader can’t be rigid. If you can find somebody who is really open to seeing anything, then you have found the raw ingredient of a good trader—and I saw that in Bruce right away. I knew from the moment I first met him that he was going to be a great trader.
He was a writer and a professor; in his spare time, he was doing some trading. I was staggered by the breadth of trading knowledge he had accumulated in such a short time. I remember the first day I met Bruce I tried to impress him with complicated concepts. Here I was, a professional trader who, in those days, spent fifteen hours a day trading and analyzing the markets, and I couldn’t come up with anything that he couldn’t understand. I recognized his talent immediately.” Michael Marcus in Market Wizards
The pragmatists take over
Traders like Marcus and Kovner were not interested in being confined to one market. After the introduction of currency futures and the end of Bretton Woods, the firm entered into currency markets. Kovner later also emphasized trading in energy.
“If the profits came from financial surfing, then the game was to spot the commodities that generated strong waves; there was no point wasting time studying sugar or wheat, for example, if these markets were going through a tranquil period. Having worked on the floor of the cotton exchange, Marcus knew what it was like to specialize. He preached the gospel of generalization with the zeal of the converted.” More Money Than God
Nor had the firm’s fundamental approach proven to be sufficient. Instead, the traders combined the research with traditional trading methods such as technicals and trend following.
“Gradual absorption of information by investors explained why markets moved in trends, as new developments were gradually digested. But market psychology was more subtle than that; there were times when investors’ reactions accelerated. Human beings do not simply make forward-looking judgments about markets, the Commodities Corporation traders recognized; they react to recent experiences.” More Money Than God
“The hardcore quants would have their day.” Sebastian Mallaby wrote, “but so long as trend surfing delivered marvelous profits, it made little sense to focus obsessively on econometric modeling.”
And Hostetter’s money management principles proved crucial:
“Marcus reckoned that he caught the wave on less than half of his attempts. But his winning rides earned profits of twenty or thirty times the small losses he took when he got stopped out of his position.” More Money Than God
Marcus combined fundamentals, charts, and ‘market action’ or what he called “a feel” for markets and their actors and behavior:
“He was a keen student of price charts, which he regarded as a window into the psychology of investors, and he focused especially on the interaction between charts and fundamentals. For example, if the fundamentals delivered bad news but the charts showed the market continuing to trend up, it meant that investors had already digested the possibility of setbacks.
He had spent time on the floor of the cotton exchange early in his career and had watched traders respond to the tempo of their colleagues.” More Money Than God
“Traders need a sense of day-to-day fluctuations. A good trader should be able to read a newspaper and from just reading the articles create a mental image of just how much his/her market would be impacted by such events. Effectively a trader should be able to determine just how many points up or down the markets would move given the news.” The Michael Marcus Tape
More Money Than God, Sebastian Mallaby
Market Wizards, Jack Schwager
Commodities Corp Early 1970s Brochure (h/t @heffernan)
There are also notes from a trader who worked with Michael Marcus called the “Michael Marcus Tapes.” If you really want to nerd out you can contact the guys at Macro Ops about it.