Hedge funds are in a sorry state, so funds that show impressive profits are real standouts.
Last month, the track record of one such fund came across my desk.
It was flagged by a hedge fund investor because the performance was so good that the investor expressed disbelief about it. I wondered how the fund made money like this.
It turns out, it’s a difficult question to answer because the fund in question doesn’t want to explain how. And that tells you a lot about how hedge funds work.
While there are high-profile investors, such as activists, whose every move is known, for most of the industry secrecy is an important part of the game. Particularly if they are small, hedge funds don’t have to tell regulators much about their strategies, even if they have outside investors. These strategies can be so complicated that it’s impossible to work out from the outside. It’s one reason that hedge fund investments aren’t open to just anyone; you’ve got to meet certain thresholds for income or assets that basically ensure you’ve got money to lose.
The fund manager in question is called (appropriately, perhaps) BlackBox Group. BlackBox is based in New York, but few people – among the hedge fund managers and the consultants who help big investors find funds – have heard of it. That might be because it’s tiny. The fund manages $17 million – peanuts in the world of hedge funds – according to a regulatory filing.
As for the performance that caught the potential investor’s eye? In 90 months of reported returns, the fund has had only four down months. On average, BlackBox’s fund posted 12.3% a year from March 2009 through August 2016, according to documents sent to potential investors. By comparison, the median hedge fund returned 6.1% net a year over the same period, according to the Absolute Return composite index.
The people running BlackBox – Brian Jones, the firm’s chief technology officer, and Michael Salemi, a portfolio manager for the firm – aren’t interested in talking about it. They didn’t return emails or phone calls seeking comment. A lawyer who represents BlackBox, Mark Ruddy, declined to comment and said that BlackBox has a policy of not speaking with the press.
One person I spoke with, who claimed to be an investor in the fund but asked not to be identified, says he didn’t know how it makes money.
BlackBox describes its strategy (somewhat) in its documents, though it’s not enough for anyone to be able to replicate. The kinds of trading it refers to – black-box and gray-box – are basically driven by computers that find opportunities in the market to exploit. That is not, on its own, unusual. Black-box trading is entirely computer-driven, and gray-box means a human is involved in the process.
“BlackBox specializes in multi-frequency systematic and algorithmic trading of equities and futures using statistical-arbitrage and relative-value strategies spread across a portfolio of uncorrelated strategies. The firm engages in both pure black-box and grey-box trading, utilizing the strengths of human research skills and risk management and a systematic, computer driven approach to strategy execution.”
“The trading platform has been in development for over a decade. Strategies include structural equity pairs, futures relative value, and intra-day directional equities and futures momentum and mean reversion. Currently AUM allocation is 80% equities and 20% commodity futures.”
Hedge funds closely guard their strategies. For instance, the world’s biggest hedge fund, $150 billion Bridgewater Associates, is said to keep its strategy close to only a few people. Bridgewater’s external PR firm didn’t respond to a request for comment on its strategy.
There’s a good reason for the opacity. The funds don’t want to give up their secret sauce, which can then be replicated by competitors. Yet it underlies a frustration that some investors in the funds have, in that they don’t really know how their money is being invested.
As for BlackBox, the performance is eye-catching, and it caught the people we asked about it by surprise. “Some of the best minds on Wall Street trade in these markets, and no one has figured out how to make 1,200 [basis points] over LIBOR and never lose money,” says Andrew Beer, managing partner at Beachhead Capital Management, an investment adviser.
Despite the consistent returns, BlackBox says it has lagged behind the S&P 500, but it did so with less volatility.
BlackBox’s documents show that it has a Sharpe ratio of 4.7. Sharpe ratios measure returns while considering the risk taken to produce those returns. Anything above 1 is a decent return, and a Sharpe ratio of over 3 is seen as very difficult to attain.
Benn Eifert, a volatility portfolio manager who previously worked at Mariner Investment Group, says that’s only plausible if the fund is investing in niche markets where it’ll never be able to deploy substantial amounts of capital. In other words, BlackBox won’t be able to keep this up if it grows any larger.
“Overall I’m skeptical,” Eifert says. “These guys are showing 4.7 over long periods of time. That is getting into territory that is really only plausible for highly capacity-constrained market-making strategies and pure high-frequency.”