Paul Tudor Jones & the Nature of the Beast

There are a lot of brilliant investors out there, but very few brilliant investors who are also brilliant communicators. It’s rare to find someone in the investment industry who has the ability to explain complex topics about the markets and investing in a way that a wide audience can understand. That’s why investors are constantly quoting their favorite lines from Warren Buffett, Benjamin Graham, Charlie Munger, Peter Lynch and Howard Marks.

These guys are legends, but they also have the uncanny ability to simplify their message.

If those five (and I’m sure I missed a ton of people on this list) are the go-to quote machines for long-term investors, the following group is not too far behind for traders: Jesse Livermore, Stanley Druckenmiller, George Soros and Paul Tudor Jones.

The last name is on the list because he’s compounded his fund’s capital at something like 20% per year since the early 1980s. He basically called the 1987 crash ahead of time. He manages billions of dollars and is worth billions of dollars.

But according to a recent story in Bloomberg Tudor Investment Corp. has hit a bit of a rough patch, so he’s been forced to make some changes in both the firm and strategy:

“We have to think outside the box,” Jones, 61, said in the letter obtained by Bloomberg. “I firmly believe the changes we have made put us in a position to be successful even in this desultory macro environment.”

Jones’s moves are central to his shakeup of his hedge fund, which this week cut 15 percent of its staff and earlier lowered some fees to stem an exodus of investors, who’ve pulled $2.1 billion this year. His remaining managers will be given more money to run, according to the letter. Some have been paired with scientists and mathematicians to bring new analytical rigor to their trading as part of a quantitative revamp of the firm.

There are a number of different ways you could interpret what’s going on here and in hedge fund land in general. Here are a few thoughts:

1. The low fruit has been picked. The 1960s through the 1990s were something of a Wild West period in the hedge fund world. There were very few funds and they weren’t managing nearly as much capital as they are today. This gave the pioneers in the industry a huge first mover advantage.

In the book More Money Than God another legendary hedge fund manager, Michael Steinhardt, very bluntly discusses some of his firm’s actions on block trading and providing liquidity during that time:

“I was being told things that other accounts were not being told,” Steinhardt says, describing the mechanics of his collusion with brokers. “I got information I shouldn’t have. It created a lot of opportunities for us. Were they risky? Yes. Was I willing to do it? Yes. Were they talked about much? Not particularly.

The regulations back then were extremely lax, so it was much easier for these funds to take advantage of holes in the system. Those types of opportunities aren’t as easily available in today’s markets.

2. Macro is hard. Investors are constantly learning more and more about which strategies and systems work or have worked in the past and are finding ways to turn those ideas into models and quantitative investment programs.

So much of it has been systematized that it’s becoming increasingly difficult for portfolio managers to separate themselves from the algorithms. Hedge fund managers in the early days weren’t competing with the computers like they are now. It’s easy to complain about the Fed, but the truth is that many of the signals these funds used in the past just don’t work as well anymore or are much more crowded than they once were.

3. Low risk free rates are hurting hedge fund performance. Many investors fail to understand how important the return on cash can be for hedge funds. In essence, hedge funds are something of a “cash-plus” stream of returns because of the way they invest. When risk free rates were 5-6%, this was like an additional premium the best hedge funds could layer any alpha on top of. With rates at 1-2% and alpha harder to come by than ever, it’s no wonder that average hedge fund returns have been abysmal.

4. There are legitimate red flags. If you are an institutional asset allocator and you looked at the following it would likely give you pause as an investor (or at least it should):

Tudor is more than doubling its gross Sharpe ratio target, a measure of risk-adjusted returns, for its main fund to about 2.25, according to the letter. And it increased the target for its portfolio’s daily price swings, or volatility, to 45 basis points.

His fund has been underperforming so by all appearances he is upping the risk in the strategy in an effort to earn a higher return. The problem is that these things don’t always work out in a 1:1 ratio. You’re not guaranteed anything on the return side of the equation simply because you accept more risk in your portfolio or fund. Changing the risk embedded in his strategy should at the very least cause his investors to ask themselves some hard questions.

Do these changes make sense in the current market environment? Does he get a pass for being a name brand investor? Have other investors caught up with him and his style of investing? Is it harder for  this fund to earn alpha, especially with a much larger capital base?

There are no easy answers to these questions. This is one of the reasons it’s so difficult to develop long-term relationships with star portfolio managers. Not only is it almost impossible to gain access to their funds, but once you do it’s very hard to know when to walk away and when to stick around. It’s possible these changes will make a difference, but it’s also possible that he’s making a mistake and pressing too much in hopes of a turnaround that never materializes.

5. He’s due for a period of outperformance. It’s also possible that he was due for a period of underperformance that will some day reverse:

Tudor, which Jones founded in 1980, hasn’t in recent years made the kind of profits it produced during its heyday. Its main fund, Tudor BVI Global, produced an average annual gain of about 26 percent from 1987 through 2007, which dropped to about 5.3 percent from 2008 through last year. The fund is down 2.3 percent this year, according to the letter. It lost 4.8 percent in 2008.

Maybe he’s due for a comeback. It’s tough to say one way or another.

Far too many investors have been waiting for the past 10 years or so for a more “normalized environment.” They assume that things will magically return to the way they once were in the past. The problem with this line of thinking is that markets and investors are constantly changing and evolving over time. There’s no such thing as a normalized environment.

This is probably more true in the hedge fund industry than anywhere as competition for both alpha and performance fees has never been higher. As the roughly 11,000 funds in this space continue to jockey for position, many hedge fund managers are going to have to make changes if they want to stay in business.

For those playing the long game that means they may have to be more patient — or find more patient investors. For those playing the short game that means they may have to be more flexible.

The nature of the markets is such that sometimes even the legends run into trouble. I’ll be interested to see if the old guard such as Tudor Jones and company can make the changes necessary to get their groove back.

Tudor Demands Managers Take More Risk in Hedge Fund Shake-Up (Bloomberg)

Further Reading:
Why Have Long/Short Funds Performed So Poorly?

Now here’s what I’ve been reading lately:


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