Oranges, Watermelons, and Godzilla

Our strategy can be (and has been) successful in both high and low vol environments. With the VIX above 20 for over a month now, we are aching to get to launch date to take advantage of some unique characteristics we are seeing in the relationship between equities and options. A high VIX probably won't affect the returns much on the equities side, but there are ways to extract more return (at no higher risk) out of the options when volatility shows certain patterns.

Think of a low vol environment as an orange, and a high vol environment as a watermelon. Now think of our fund as Godzilla, who is very thirsty right now. Godzilla squeezes the orange with one hand, and the watermelon with the other. He will get more juice out of the watermelon.

We squeezed mostly oranges over the last four years and it was a fine thing, we did very well. Now it's time to mash some watermelons.

John Galt would be very proud of this analogy, by the way; it was he who coined the phrase "mastodon burgers".

A little history is needed

What, you thought that we came up with our investment strategy overnight? Well, let me tell you that it took all of Thanksgiving weekend to think this up. It's amazing what you can come up with given a pad of paper and a couple of bottles of Jack Daniels.

OK, the truth is that this concept has been brewing since 2002, and was put into practice with real client money almost four years ago. So we have had 15 quarters to work through things. We set the S&P 500 as a target each quarter, and tried to beat it in a variety of different market scenarios (up market, down market, volatile, calm, different asset classes leading the way, etc). The net result was that we beat it 14 times out of 15, and the one miss wasn't bad at all. We had eleven up months in a row at one point, and consistently stayed about 7% ahead of the market annually. Meaning that the market averaged about 10% up over that time, and we were up a little more than 17%. Certainly not like Renaissance or D.E. Shaw, but then again, we were operating with many restrictions in place in a brokerage environment. Sort of like backstroking through Cheese Whiz with your right hand handcuffed to your ankles.

Since the other main goal was to bring the volatility down, we worked hard at doing that at the same time. Equities had a standard deviation of around 15% during that time, we got ours down to 4% annually, below the price variation of bonds. There was some luck in there, but enough skill seeped through that we thought the concept was proven. That and a stackful of papers from academia that said the strategy was solid turned out to be more than enough to launch.

It also doesn't hurt that two of us are ex-Goldman Sachs guys, and every day there is something in the paper about how ex-Goldman guys are running the world. We don't plan to run the world, but we do plan on running most of the money.

So we did not enter into this little venture lightly. We figured if big institutions with $100 million+ to throw around didn't like us personally, they might at least like the past investment history, or the academic seal of approval, or the pedigree, or the fact we are not in New York. Give them a big enough menu, and they'll find something they like.

Who is John Galt?

I mentioned the other day that there are two other architects in this effort to build a world-class investment institution. One of them is a fellow I've known for nearly ten years. In fact, this is our third time working together. He is a Renaissance man in nearly every sense of the word, although I'm not sure he knows how to paint. He has his fingers in many different business ventures, some of which he has stakes in, others in which he merely maintains a high level of interest. Yet he prefers to remain anonymous. His name is nowhere to be found on our marketing material, nor in our organizing documents, yet he played a major part in creating each. Like Ayn Rand's hero, he works his magic behind the scenes. So we will call him John Galt for the purposes of this blog.

In many ways, he is a pure intellectual fellow, with his mind always revving at 8000 RPMs or higher. I worked with him at Goldman Sachs during my time there, and in subsequent places since then. Galt has an Ivy League education with advanced degrees and has shown remarkable proficiency in three very different industries so far. He has sold a company he started within the last year or so and has had a great impact in moving this hedge fund from the conceptual stage to the trading stage.

Galt is the kind of guy you should go to lunch with if he calls you. Because at some point, he will call you. He has an amazingly deep contact list, and leverages his existing contacts to make new ones every day. He will have read everything you have read before you read it. Plus he will have read everything you haven't read. Galt is the first to know everything, both truth and rumors. His ear is permanently scarred from having been affixed to the ground his whole life.

So while I may get a great deal of the credit for the extraordinary success (or abysmal failure) of this investment vehicle, realize that John Galt had a momentous impact on that success (but not any impact on a failure). I will refer to him frequently as this blog progresses.

Hello Recession

We officially have a correction on our hands (down 10% in less than two months) and I am highly amused by the whole thing. In fact, I almost snarfed ice water on my keyboard yesterday when I thought of how we got here. Most experts are saying that we are entering a recession, and I agree. We've probably been in one since late summer, although you never know on these things until months down the road when some government bureaucrat puts out the official word.

It's always funny watching the flow of money during volatile times. If most U.S. taxes tend to transfer wealth from rich to poor, then markets like these tend to transfer them back the other way. It is obvious that big commercial banks are getting hammered during this credit crunch. Citi has been chopped nearly in half, and others are doing almost as badly. Goldman, on the other hand, is doing quite well. Either they don't have a sub-prime problem, or they do, but they hide it well and can write down the assets quietly over a period of several quarters to smooth out earnings.

You could see this coming a mile away over the last several years. Why would an entire industry suspend its rules and guidelines to make money in the short-term, only to lose much more than that in the long-term? It's like putting together a portfolio by throwing darts at the stock tables, except all of the good stocks have already been blacked out. Actually, it's worse than that. It's like snarfing ice water a thousand times and thinking it will never hit your keyboard.

This sets up the smart rich folks once again. Anytime there is a firesale situation (and believe me it's coming), they will swoop in just as the blood is spurting out of people's ears and running down the street. They will buy when Time magazine declares the sector dead. And they will make anywhere from 30% to 200% in a short time when things turn around. Remember that they control when it turns, too.

So I expect a trading range environment for a while. Given the strategy we are running here, that will be ideal for us. We don't tend to focus on individual sectors too much, but we may do some cherry-picking shortly. Some are nearing the bottom, others haven't felt the impact yet and have plenty of room to come down.

I am looking at homebuilders, banks, and the VIX very carefully today.

36 Days Until Launch...

...and the first day in our office space. Right now I'm sitting in a cubicle that is no more than 5x5, and I'll probably be here until a real office opens up down the hall early next year. We have decided to save money in certain areas at first, and office space is one of them. I cut the cord with my former employer last week, so my income is back to zero for a short while.

This initial entry comes well into a nine-month process to build a private investment partnership. There are three primary architects of this effort, plus a silent partner. I will introduce the other fellows in subsequent postings.

At the risk of boring you to death, a little bit about me: I have managed money professionally for over ten years at a handful of investment banks (Goldman Sachs, Morgan Stanley, and Citi among them). Somewhere along the way, I found that I was pretty good at keeping the risk down and the returns up. So I kept tweaking things and backtesting data and generally started living inside a spreadsheet until several of my friends and clients encouraged me to start a hedge fund. I was fortunate enough to partner with two other very smart and experienced individuals, each with far more credibility than myself. I'm 38 and married with three daughters. My degrees are from Duke and Georgia.

Today I have already signed up for a parking pass and brought a 75 pound color printer up seven floors. Bloomberg is supposed to get back to me in 24 hours about getting access to a terminal. I need a power strip so that the cord to my lamp can stretch to the wall socket so I can see better. It's a far cry from the ivory towers I've come from thus far, but it feels far more worthwhile.

There will be a few things I will not directly address in this blog. One is the identity of clients, for obvious reasons; another is the exact amount of assets under management. A third item is the detail of the investment strategy, although I will certainly discuss it extensively in more general terms. (At its most granular lavels, the strategy is highly quantitative and makes liberal use of derivatives, and timing is also an important factor, so trying it at home without professional guidance is probably a bad idea.) One of the architects of the firm has chosen to remain anonymous for a variety of reasons, so I will identify him by a pseudonym in future posts. Otherwise, the playing field is pretty wide open.

I'm having a blast already - why in the world was I ever working for the man?