What's your edge?

The three-ring circus that is global finance continues to astound and amaze, with noise levels approaching jet-engine thresholds. Mean reversion has been the order of the week to date, with whippy price action and WTF? headscratching as standard operating procedure.

At least one source of uncertainty should be resolved-to a degree- today, as Merrill Lynch finally reports Q3 earnings at 7.30 EDT this morning. Press reports suggest that another $2 - $2.5 billion will be written off, though as noted yesterday speculation is rampant that the all-in write-down could be as high as $15 billion or so. Meanwhile, a high-profile market-maker on Eurex has gone bust, further increasing market jitters. Oh, and the the situation in southern Turkey remains perched on a knife-edge. Are we having fun yet?

In stressful markets like these it is often useful to look inwards and remind yourself of what your edge is. One of the most commonly-asked questions of traders and fund managers is "How do you make your money? Why should you be expected to generate consistent returns?" Unsurprisingly, saying "I buy 'em if I like 'em and I sell 'em if I don't" is rarely deemed to be a satisfactory response.

When Macro Man looks in the mirror and engages in a bit of Delphic introspection, here's where he sees his investment advantages:

Process
* Combining beta-plus and alpha strategies is an excellent way to maintain market participation during favourable conditions while retaining the flexibility to either add or dial-down risk as circumstances warrant. Pure quant strategies tend to get caught out by fat-tailed risk events, as in August. Pure discretionary traders, meanwhile, can on occasion get caught up in noise and lose sight of the bigger picture.

* Of course, a process is only as good as its inputs. Macro Man's relatively simple models are meant to get him out of the market when conditions deteriorate; while there is no guarantee that they will always work, they nevertheless kept him out of the FX carry debacle in August, for example. As such, his "beta plus" foundation would appear to enjoy a comparative advantage over passive exposure strategies.

* At the same time, models clearly don't capture the whole story. Profiting from temporary or non-quantifiable factors can be an important soure of alpha. Managing risk on the basis of things that models cannot "see" is, in Macro Man's view, a vital element to chopping off the nasty tails lurking at the left side of the return distribution. Of course, there is no guarantee that he will always manage to do so; however, having the ability and, vitally, the intent is more than half the battle.

Skills
* Macro Man is able to develop, backtest, and implement simple models. He is not a "quant" who creates "black boxes", but he is nevertheless able to develop a hypothesis, create an 'experiment', and act on the results. By doing the numerical work himself, he hopefully has a clearer sense of a model's strengths and weaknesses than if he were implementing someone else's work.

* Macro Man has a pretty good grasp of macroeconomics and has closely followed the data in key markets for a number of years. He is comfortable with his own sense of what matters and what does not, and the key drivers of the economic cycle. He doesn't always get it right- nobody ever does- but he at least has the ability to critically assess the forecasts that are "in the market" and look for mispricings or incipient swings in sentiment.

* While not a "mine-yours, shag" trader, Macro Man nevertheless has a reasonable grasp of charts, positioning, and the psychology of high-frequency or market-making traders. He relies on these skills not only to identify when price action is noise, e.g. the last couple of days, but also when there is actionable signal. Again, it doesn't always work, but it's a useful arrow to have in one's quiver.

Psychology
* While Macro Man is confident in his ability, Macro Man knows that he is not bigger than the market and is never afraid to admit that he is wrong. He is willing to take losses when "the facts change" and has learned to scale his position sizes in line with his conviction levels. He tries very hard indeed to avoid the error of confirmation bias that seems to plague so many financial market particpants; maintaining an objective outlook should confer an investment advantage.

* Separating noise and signal. When Macro Man is trading well, he tends to fixate on a few key themes and filters out the noise from just about everything else. This (hopefully) allows him to avoid the sin of over-trading or headline-chasing; his analytical expertise is not in the short-term, so he should not get caught up when decibel levels rise. His current thematic focus is on the continued abundance of global liquidity, the looming threat of global inflation (which should eventually cause the removal of liquidity), and a secular rise in financial market volatility.

* Knowing what you're good at. Macro Man is a reasonably dab hand at currencies, knows US equity indices pretty well, and isn't bad at government bonds and swaps. He lacks expertise in single-name stocks, credit, and commodities, which is why his risk allocation to those sectors is relatively low. There's nothing worse than being blind-sided and losing lots money in a market that you don't really know, something that happened to a few of his commodity punts early in the year and in 2006.

A final comparative advantage that Macro Man enjoys is this very space. For better or for worse, his brain is hard-wired to develop and refine thoughts through expression; put another way, his ideas are better when he writes them down. Maintaining a paper P/L has also enabled him to try out new strategies without taking a real hit; the aforementioned commodity losses, for example, were only on paper, and taught Macro Man that commodities aren't as easy as they look.

A final advantage of this blog is the ability it confers to exchange views with largely anonymous but nevetherless widespread and thoughtful segments of the investment universe, both professional and retail. This occurs in the comment section, offline, and via the occasional poll: was there a better equity buy-signal than the lack of "V" responses in August?

So there you go. That's how, where and why Macro Man thinks he can be successful. While he generally refrains from offering advice directly to readers, in this case he'll make an exception: Know thyself, and your P/L will thank you for it.