The Secret to SAC's Returns May Be Weirdness

SAC Capital CEO Steven Cohen
Scott Eelis | Bloomberg | Getty Images
SAC Capital CEO Steven Cohen

The Wall Street Journal's look into SAC Capital's trading is somewhat shallower than its length suggests. This isn't the fault of the Journal reporters, who clearly did a lot of work digging through public filings to unearth unusual trading patterns and well-timed trades. Yet it's hard to tell exactly what it is that SAC does to consistently beat the market, because not much is revealed about how it trades.

SAC's quarterly disclosures are not quite useless—but nearly so. They only provide a snapshot of the fund's positions at a small moment in time, which isn't very useful when SAC is said to make rapid and frequent forays into asset markets. What's more, these filings don't say anything at all about short positions — which no doubt make up a sizable piece of SAC's portfolio.

However, there is something that can be teased out of what the Journal reports, something that might help explain SAC's returns.

The Journal filtered SAC's trade through a lens intended to measure market timing. The story looked at how often SAC's acquisition of a company's shares was followed by a single day gain of 15 percent or more, and a monthly gain of 10 percent or more. According to the article, this phenomenon occurred 187 times in the last six years.

That's pretty heavy exposure to upside surprises—although exactly how much is difficult to determine. According to the Journal, SAC Capital is about in the middle of the pack with similar hedge funds when it comes to its ability to time the market in its favor.

From the point of view of the enforcement division of the Securities and Exchange Commission, this at least suggests insider trading. At the very least, it suggests informed —if not illegal — trading.

This suggestion is confounded by the fact that even more frequently than upside swings, when SAC buys a stock, it often drops suddenly. If non-public information were behind SAC's abnormal returns, you'd expect their traders to be able to avoid this kind of thing.

So what is SAC doing? If markets are efficient, it should be possible for anyone to consistently beat the markets. Yet the firm isn't just beating the markets, it is blowing them away: it averages a gain of 30 percent a year for twenty years.

There are two ways SAC could accomplish this. One is the use of non-public information. We know that this went on to some extent, thanks to evidence that has arisen in various insider trading cases involving former SAC traders. Yet none of the evidence presented so far suggests that insider trading could explain entirely how SAC maintains its edge over the market.

The other way SAC could be achieving these results is by focusing on market areas where efficiency is hampered. This means that for some reason or another, arbitrageurs cannot correct mispricing, or new information is not quickly translated into stock prices. If arbitraging is too costly, for instance, it may be that prices stay out-of-whack long enough for a risk-taker to pounce.

What could make stock arbitrage too costly for certain stocks? Probably the most common thing would be weirdness. When a stock is very weird, when its price doesn't correlate very well with other assets, it becomes costly to develop hedges against positions taken in it. The technical term for this is "idiosyncratic volatility." When a stock behaves as if the rest of the market didn't really exist this means that risk adverse investors will not be willing to exercise efficiency creating pressure on the stock.

A paper published in the Financial Analysts Journal in 2009 explored this strategy. "When is Stock-Picking Likely to be Successful? Evidence from Mutual Funds" found that mutual fund managers exhibit "stock-picking ability for stocks with high idiosyncratic volatility but not for stocks with low idiosyncratic volatility."

The frequency with which stocks in SAC's portfolio see large jumps suggests that they are seeking weirdness —stocks that behave idiosyncratically. This would also explain some of the structural things we know about SAC. The way it's divided up into many small teams suggests a search for oddities. The same with the way traders are expected to present their best ideas to Steve Cohen, the fund's founder.

Another way to take advantage of idiosyncrasy would be to have the skill to develop cheaper hedges. That is, if other traders are avoiding a stock because they cannot figure out how to hedge their exposure, the ability to hedge would create an edge. One trader I spoke with who worked at SAC Capital said he believes this is part of SAC's ability to beat the market.

The SEC is no doubt frustrated that it hasn't been able to get to the bottom of SAC's returns. Maybe they just aren't paying attention to weirdness.

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