How The Brilliant Co-Founder Of A $250,000,000 Hedge Fund Is Killing His Company


I had the chance to catch up with an old friend recently.  He’s the co-founder and manager of a small [$250,000,000 assets under management and yes, that’s small these days] systematic hedge fund here in the United States.  Our friendship originally developed over the 5 years that I “covered” him for my old shop. 

Let’s call him Roscoe too.

Roscoe is smart… like uber smart.  Like start at the ground level (Hollywood’s Mail Room) and work your way to portfolio manager of a $1,000,000,000 fund at a major, global mutual fund within 14 years smart.  Like co-found a hedge fund with your business school professor [and world expert in the space] smart.

But he doesn’t believe he’s smart.

He thinks he has to run at top speed all the time, just to keep up…

To prove that he’s smart… that he belongs.

And it’s killing his fund.

Don’t get me wrong… He’s doing all of the right things according to his methodology.  According to traditional finance.

Theirs is a fundamental systematic approach.  

And no, that’s not an inherent contradiction.

In essence, they’ve done deep fundamental research and discovered a large number of variables that when present and tilted in just the right way, they yield superior risk-adjusted returns.

Superior again, according to traditional finance.

Except the approach hasn’t yielded even those results for the last 4 years.  They were flat for the last 3 years and they’re down about 10% so far this year.

I know what you’re thinking… “In THIS market they’re flat to down over the last 4 years?”

Yup… flat to down.

"It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong."

-- Richard P. Feynman 

Being the curious sort, I asked him what he thought the problem was with performance.  Is it the variables they use?  Is it the level of correlation between some or all of the variables?  Do they think they’re missing a variable?  I also asked what response he’s getting from his investors… and what he planned to do.

His answers stunned me a bit… but also reminded me why the vast majority of money managers underperform against their benchmarks… to say nothing of absolute returns.

Roscoe’s short answer with respect to performance was simple… 

The market is wrong. 

He went into mind-numbing [for me anyway] detail about how fundamental value has been tossed aside in lieu of GAAC [Growth At Any Cost].  How less “valuable” companies are trading at a premium because of their marketing heft as opposed to because of their operating performance.  He even shared a well written white paper he wrote on the topic recently.  I won’t mention the exact title, but suffice it to say that both title and body suggested that everyone else is on a fool’s errand and value will inevitably outperform.

I remained silent.

"There is only one side of the market and it is not the bull side or the bear side, but the right side."

-- Jesse Livermore 

He then told me that some clients were getting a bit nervous… but that the firm hadn’t had much in the way of redemptions… yet.  

He also said that he thinks he’s found a significant new pool of investors.

I didn’t have the heart to tell him after that last bit that that sounds more like a Ponzi Scheme than I think he wants.

"Rules are not necessarily sacred, principles are." 

 -- Franklin D. Roosevelt

Roscoe is really killing his fund in 3 distinct ways…

  1. He’s disavowing a cardinal rule of trading… TAOST Principle - The Market Is Always Right.  There’s neither argument nor debate on this subject.  Someone ALWAYS knows more than you… and the best reflection of that collective body of knowledge is via the price performance of a liquid, freely traded security.  When you can be “right” about all of the data… sales projections… expenses… industry growth… etc. and STILL lose money because the market disagrees with your thesis about what that means, it’s time to stop trying to adjust the wind and to start adjusting your sails.

  2. Roscoe is also attempting to use the markets to prove/affirm to himself how smart he is by making predictions based on his analysis of fundamental minutiae… a violation of TAOST Principle - Your Most Important Capital Is Your Emotional Capital. The market is not the place to seek emotional fulfillment. If you need to feel smart, take a class/test. If you need drama, find an unstable person and try to develop a balanced, fulfilling relationship with them.  If you need unbounded risk, take sky diving lessons.  Don’t try to use the market to fulfill these needs… it’s not likely to work out the way that you think it will.

  3. Finally, while perhaps the right approach in a % of assets under management world, focusing on growth via increased AUM [as opposed to through performance] is the antithesis [or should be] of money managers. The average investor in a mutual fund needs growth… and significant growth at that.  Not a holding place to provide income to the money manager… and little else.

What’s my point in all of this?

Not much… other than to tell you once again that you shouldn’t get caught up in the traditional personal finance rhetoric… also known as nonsense.  And that you should focus on strategies and processes that deliver profits… Not a salve for your ego.

Your accounts will be better off for it.


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