Michael Kean: Complementary Strategies
When Michael Kean was a university student in New Zealand, he started investing in stocks as a hobby. Ten years down the line, he started his own management company, he achieved a 29% average annual compounded return (almost triple the S&P 500 return which was 11%). However, he kept his maximum drawdown under 20%. His monthly Gain to Pain ratio was also nearly triple the corresponding S&P figure: 2.86 versus 0.96.
Ironically, trades that appear highly risky are a core component of Kean’s risk mitigation strategy—e.g., short biotech stock positions held into clinical trial announcements, and shorts executed after overnight price gaps triggered by corporate announcements.
Proper risk management comprises two tiers: the individual trade level (limiting the loss on a single trade) and the portfolio level.
At the portfolio level, there are furthermore two components. First, similar to individual trades, there are rules to limit the loss of the portfolio as a whole. Such rules include a defined process for reducing exposure as a loss drawdown worsens or a specified percentage loss at which trading is stopped.
The second factor of risk management at the portfolio level applies to the portfolio composition. Positions that are highly correlated would be limited to a feasible extent. Ideally, the portfolio would include positions that are not correlated and, even better, inversely correlated with each other. The idea of building such a portfolio is the essence of Kean’s trading philosophy. Any long-only equity portfolio has a problem that most of the positions will be highly correlated.
The majority of Kean’s portfolio consists of a long equity component (approximately 60% on average, although this range depends on Kean’s estimation of the prevailing return/risk of the market).
Kean solves this problem of a portfolio by combining the highly correlated portion with long equities that are inversely correlated to that portion. The trading portion of the portfolio consists mostly of very short-term trades and a lesser extent of longer-term short positions in the biotech sector. The inverse correlation stems from the fact that almost three-fourths of the short-term trades, and also the longer-term biotech positions, are short positions.
Even the long positions of the trading portion and investment holdings are uncorrelated because they are day trades linked to company-specific events. By combining two inversely correlated components, Kean can extract the long-term appreciation in equities without the typical downside exposure of long equity portfolios in bear markets.
Kean’s unique method of hedging his long equity exposure is not applicable or advisable for most traders. It is not the specific method that Kean uses to reduce portfolio risk that is appropriate for readers. Instead, it is the concept of seeking uncorrelated and, preferably, inversely correlated positions that is important. Traders need to focus not only on their trades but also on how these individual positions correlate with each other.
Michael Kean also applies risk management at the individual trade level with unlimited risk. He learnt the importance of limiting risk on individual trades early in his career when he shorted a stock in a parabolic up move without a contingency plan. The stock price nearly doubled, resulting in a 10% hit to his portfolio—his worst loss ever. He never repeated this mistake.
Kean typically limits the risk to 1% on his biotech trades, his area of expertise, and to only 30 basis points (bps) on non-biotech trades. He generally enters a large-cap holding only after a sizable retracement, limiting further downside in these positions.
In late 2014, Kean let his discipline lapse. He was 35% up for the year. Thus, he felt he could take more risk, given his profit cushion. He bought a group of energy stocks because the sector was down sharply. It had nothing to do with his standard methodology. Within two weeks, he had sacrificed 7% of his profits for the year.
It is very common for traders to become careless when they are performing well.
A trader should be aware of letting such strong performances get to their heads. Persistence is the key to develop a decent edge in this long journey. One has to identify that edge and develop a trading process accordingly. Mistakes teach us a lot when analyzed. Lastly, trading should be done out of love so that one can survive through tough times.