How I Use The Machine: An Interview with Darrell Kay of Kay Investments Inc.

On Friday, August 27th, TradingMarkets Editor in Chief David Penn conducted a brief interview with investment advisor Darrell Kay of Kay Investments Inc. In addition to having more than 20 years in the investment business and more than 10 years as an investment advisor, Darrell Kay is among the first to have begun adding the quantified, portfolio-building capabilities of The Machine® to his business as an investment advisor. What follows are some insights into the challenges of being an investment advisor and, most importantly, even more fascinating insights into how Darrell Kay uses The Machine.

For more information about The Machine and to save your spot at the next presentation on The Machine by TradingMarkets founder and CEO Larry Connors, click here.

David Penn: How long have you been an investment advisor?

Darrell Kay: I started out in the investment business in 1986 when I got my series 7 license. I started out as a broker rather than an investment advisor. I started Kay Investments in May of 2000, so I’ve been in the RIA business for 10 years and a couple of months.

How did you first become interested in managing other people’s money?

There are several things that appeal to me about managing money. It is a people business, which I enjoy. And it is a business that I find interesting for the content of it – it is a good match for my analytical abilities. I also thought that managing money was a good way of earning a living if you could get past a certain threshold of AUM (assets under management).

How did you manage your client’s money before you discovered The Machine?

I tried to manage money actively. Let’s start out with that. I tried to identify good areas where to place money. But before The Machine, I struggled with where to accurately source my information.

I subscribed to one pretty pricey newsletter that identifies sectors. And I also subscribed to another pricey newsletter that, among other things, did successfully identify the bear market in 2008.

The problem was that the sources really weren’t precise enough and didn’t do the job effectively. For example, the first newsletter I mentioned missed the recession and bear market of 2008, and the other missed the entire 2009 bull market.

What were the biggest problems you had before you started using The Machine? How has The Machine helped you with these problems?

I was looking for an analytical, precise method of managing market movements. Of course, the business schools always say that those methods don’t exist. But I did a lot of investigating, read a lot of different books and articles, investigated different methods – including, for example, neural networks and artificial intelligence. I did research into options, always looking for what is commonly called an “edge”. That’s the term that Larry Connors uses.

Interestingly, one of the articles that I read regarding neural networks references one of the books that Larry wrote. I bought two of Larry’s books. That brought me to The Machine.

What attracted me to Larry’s books, and then ultimately to The Machine is the fact that both were 100% quantified. So it took subjectivity out of the equation. That was a big relief for me. It is very stressful relying on what you think is going to happen, or wondering whether the information that you are relying on is really accurate.

It also seemed to be robust. By that I mean it wasn’t, for instance, one set of analysis based on one security and another set of analysis based on another. The research was just simple signals that had been backtested on thousands of symbols. So, for instance, when I read that such and such made money 80% of the time based on 330,000 data points, that seemed to me like it could work.

And the more I investigated, the more it seemed like I could probably rely on it. It answered the simple, simple question: show me something that can work – and not require me to interpret anything subjectively.

What types of portfolios do you create using The Machine?

I’ve run many iterations of portfolios to arrive at what I use today.

Being an investment advisor, I really don’t want to run lots and lots of portfolios. So I only run two. I run one that is long positions only that’s suitable for IRAs, and I run another that is identical to that but also has a couple of short strategies.

Along the way I’ve built many portfolios and the emphasis I’ve always placed on them is risk management. That doesn’t mean that the portfolios I use don’t show high returns – they do. For example, I use only strategies with 10 slots [maximum number of positions]. I try to use as many different strategies as I can. I also strive to use 1% positions only. Of course, it is true that sometimes there is an overlap, and that is one reason I start the position sizes at 1%. That’s one key feature that I’m building in here.

I’m also looking for lower drawdown strategies and a third thing I pay attention to is success percentage.

Actually there is one exception to the statement I just made. I use a higher slot size, for example, on some of the scale-in ETF strategies that have high probability of success. I’m talking about, for example, over 80%. I like the 5 stage scale-ins, 1-2-3-4-5. So that is an exception to the 1% rule.

Do you use the new trend following strategies?

In terms of trend following strategies, I use them for a couple of reasons. For one thing, it is intuitive to clients to think that they are holding some longer term positions, that we are not just building a mean reversion program. So I present trend following as a core strategy, with shorter term strategies built around that. We talk about how historically by design, the trend following strategies gradually cash themselves out when the markets fall [i.e. the positions are closed as the trend reverses]. You get out of them when the bear market hits.

I also use trend following because there are periods of time when the market is trending. They also have an effect of smoothing out returns.

How do you feel about the fact that your portfolios have relatively high cash levels the majority of the time?

Initially it seemed like it was going to be a disadvantage or a problem. I felt that even if I could get over the issue, clients would think that’s a bad thing. However, what I found in practice was that the clients, many of them, have expressed a positive attitude toward that because they feel that it is more risk averse.

Of course, I would like to find a way to get that cash to work a little bit.

So it has not turned out to be a problem. First I had to get over it. And once I got over it and made peace with it, then I realized that maybe the clients would also. And so they have. I think it’s a matter of, number one, presenting it correctly to the clients. By that I mean describing cash as an opportunity. And secondly by presenting it also as a risk management tool. And right now risk aversion is extremely high and is an extremely important factor.

I’ve always found over the years that eventually, managing risk is the most important thing we do and is the most important factor in the client’s thinking. It is a rare client, certainly among ones that I do business with, that places risk management at the bottom of the list. Most clients put it up at the top. And the cash positions are kind of comforting. Much more often I’ll get a reaction that’s more along the lines of: “We really generate this high a return on the portfolio even though the average position allocation is only 30%?”

So there’s a little bit of disbelief that we can get all of this done with this much money in cash. But ultimately that’s comforting to them. And it helps them be even more impressed with what The Machine does.

Do you use The Machine to build IRA or retirement portfolio?

Yes I’m not using portfolios that are ever likely to be on margin. I’m very happy with that. You do need to use a broker that will allow you to place orders which could take you over 100%. In other words, they’ll accept the limit orders, but once you get to 100% in the IRA account it will just stop filling those orders.

That’s important. You don’t want to be with a brokerage company where they won’t even allow you to place the orders because if they get filled, it will exceed 100%.

You really don’t need margin, in my opinion. Even though my models are pretty aggressive in the total allocations, (they are over 100%), the historic fact is that they still only average around 30%. And that’s where they sit today so it’s really not on my mind at all.

In terms of specific portfolio building, I go one strategy at a time and try to use all the strategies. Let’s start with that. I’m maxed out on strategies. I want as much diversification among the strategies as I can have. So let’s take that as point one.

Second, when I go into a strategy, I’m not looking for the maximum return on that strategy. If you were looking for maximum return, then you’d just put all your money in the highest return strategy. I’m looking for some combination of low drawdowns and high success percent and high average P/L. And interestingly, those three correlate, so if you sort on any of those criteria, often times you are looking at a high sort on the other criteria also.

How do you see yourself using The Machine going forward?

I think what will happen is that new enhancements will be coming to The Machine and I look forward to those enhancements. I will change the way I do things as The Machine changes. One thing I would love to see, of course, would be ever more different types of strategies that diversify more and more and more.

But how do I think I’ll be using it? I don’t see a change other than to react to the changes of The Machine itself.

What advice would you give to other investment advisors and money managers?

First, I think you need to practice building portfolios quite a bit. Just play with it – for lack of a better word. I’ve spent hours doing that. And I’m not working with the same portfolio, for instance, that I was using originally. I used one portfolio with my own account for three or four weeks. Then I threw it away in favor of something I liked better. It’s an evolutionary process.

The other thing that you have to do is get into a routine regarding implementation. I have my own routine for getting the information out of The Machine and into the actual order list where I’m buying and selling. And, of course, that’s only going to get easier because of enhancements that are planned.

An advisor also has to form a different mindset. We’re all set in our ways. And if a person isn’t comfortable with changing things, then it’s going to be harder. It is disruptive. This is a very disruptive technology. But it is disruptive in a very positive way. It is going to require adjusting.

Is there anything else important you could share?

If I passed along something to advisors, I’d pass along to them the idea of being very careful not to be overly influenced by the “buy and hold” religion promoted by the mutual fund industry.

I know from 20+ years of experience that the industry, depending on which part of it you are in, tries to influence thinking to sell products. Of course, business schools influence thinking too. It took me years to reconcile the efficient markets concepts from business school with my search for active strategies. So an advisor could very easily think that this technology just is not capable of working and not give it a closer look.

The Machine is a strategy that might not have been workable five years ago for us advisors. In summary, it is important to overcome preconceptions.

Individual investors are a different group. I think an individual investor who manages enough money so that the cost side of this works will probably adapt more readily than an advisor – if that person is sufficiently hands on. People are different: some are more hands on and some are less so. So the right investor might overcome preconceptions more easily than an advisor. Advisors as a group are heavily influenced by industry attitudes, industry mantra and inertia.

As a final point, I would add that my experience with The Connors Group in general has been positive. When you get married you want to make sure that your spouse will be someone you are going to be compatible with. And I’ve found my working relationship with The Connors Group to be a good one. You’re not just buying a product, you’re buying a relationship.

Thank you very much for talking with us this afternoon.

Thank you. You’re welcome.