Malachite Capital’s niche strategy fueled a 22.3% return in 2016. Co-founder Weinig explains why niche strategies are attracting capital over long-short and macro-driven funds.
With many hedge funds facing a challenging climate, niche strategies are generating greater attention due to their ability to provide differentiation, more value, and take advantage of less crowded positions.
In December, Modern Trader profiled Malachite Capital co-founders Joseph Aiken and Jacob Weinig, whose fund has grown its AUM from $30 million to roughly $300 million in a little more than three years. In 2016, the fund returned 22.3%.
During the first three months of 2017, the fund was up 7.95% compared to 5.53% for the S&P 500. The fund’s Sharpe ratio sits at 2.4.
What’s the strategy? The two managers have discovered an uncorrelated source of alpha that not many funds have been looking to capture. Its niche is in global equity derivative products. The fund has a market neutral or ‘vega’-neutral return profile, that they have created by taking advantage of inefficiencies in the global equity volatility markets.
This month, Modern Trader decided to dig deeper with Malachite co-founder Jacob Weinig to better understand their success with a niche strategy.
Modern Trader: Why have hedge funds failed to match the performance of the S&P 500?
Jacob Weinig: Well, first, people have to keep in mind that hedge funds are not designed to outperform bull markets. But when looking at all of the evidence, macro funds have not been able to outperform given their size and exposure.
Many hedge funds have gotten so large that they got away from what made them work. They aren’t investing in small companies that can outperform the markets. The next place this industry can and will succeed is in niche strategies that allow managers to focus on places and products where others are not looking.
MT: You’ve made the case that the differentiation, opportunities and results you’re enjoying are direct results of a shift away from long/short and macro driven strategies. What have been the benefits to having a niche strategy?
JW: Niche strategies are very important to raising new money. We are relatively young managers. We didn’t have experience at hedge funds. I spent my entire career at Goldman Sachs. Joe was at Citigroup and Goldman Sachs. It’s not a traditional background for raising capital. But as time passes, people with similar backgrounds will start trying new strategies. One of my favorite things about us is that we’re not a traditional hedge fund. We weren’t trained to look at the world from a trade-first perspective. We were trained to look at the world from a product-first perspective. When we were at banks and we were selling, trading, structuring, and designing these products, we really thought about product first. Where are the inefficiencies? How do we think about fair value? And once we think about that, how do we place it based on the firm’s exposure? That’s very different than the traditional methodology.
MT: Talk about the volatility space. How has it evolved?
JW: It’s very hard [to argue] going back 10 to 15 years that volatility was an asset class. Now it’s a very hard argument to make that volatility is not its own asset class. The major things that have changed are market depth and the diversity of players. Before 2008, if you weren’t on an equity derivatives desk or worked at a large sophisticated hedge fund, you might not have even known what the VIX was. Today, I can’t turn on CNBC or Bloomberg for 30 seconds without hearing about how volatile things are [and] where the VIX is.
MT: Are you placing trades on a discretionary basis or is it all systematic?
JW: Every single trade we do is discretionary and signed off on by Joe and myself following both quantitative and qualitative diligence. Anyone who runs a fund or a strategy looking at historic data is trying to convince themselves of something. Volatility data from five years ago has no role in determining reactions in today’s market; the market is completely different than it was just a few years ago.
We don’t have a computer telling us what, when and how to trade. We certainly have models that will flag ideas to us, however, at the end of the day; we need a qualitative story as to why these opportunities exist.
I ask myself different questions on every instrument we trade. I want to understand every player in the process. I want to understand their motivation. How do they think they’re making money? What is their edge? And what is the bank’s edge?
The bank is the most important player here. If we don’t understand how they’re making money, or attempting to make money, then we probably don’t understand the product.
MT: You said that it is not really how you look at volatility. You don’t care about the history; it’s more about the qualitative assessment of what’s happening now. That’s a unique approach in an age of quantitative analysis and artificial intelligence: Explain.
JW: It’s critical for our team to take that approach. My co-founder Joe was a mathematics major in college. I was a chemical engineer. We think we have the quantitative side down. So, we really over-value the qualitative aspect. It’s central to the network we create and the people we hire and speak to every day. The information we try to gather is unique so we can determine why these opportunities exist. It’s really important that we try to make sure that we get all the angles right and know how investors, banks, retail players and insurance companies are using these products. The quantitative approach is fine, but understanding the story behind the trade is so much more important. Once we understand how everyone’s involved in making money, we start to understand why this opportunity is available to us. We try to create scenarios in our minds for where all of these things happen. And we don’t just ask if these things have happened before.
MT: Do you ever hedge your trades or have directional exposure? Or are they always pure arbitrage plays?
JW: The way we construct our portfolio, we have a long volume bucket, a short volume bucket and a pure [relative value] bucket. The long and short, though, will always be offsetting in size. We’re happy to take a directional risk on certain positions, but not overall on the portfolio.
We have a very concentrated portfolio. Typically, we have 15 to 20 trades on at any given point in time.
MT: What is your capacity?
JW: This fund today is just under $300 million. We have told our investors that we will close fundraising as we approach $1 billion. We would much rather be a really strong $1 billion fund where we can really outperform and take advantage of less liquid, more idiosyncratic opportunities. We prefer that to running a multi-billion-dollar fund, where we’re limited in what we trade.
MT: Is anyone else in your world pursuing a similar strategy?
JW: There are certainly teams within multi-funds doing this. But there are big differences in things that we don’t fundamentally agree on. For example, one fund may trade a lot of correlation using dispersion products that we don’t trade. There are differences obviously when we trade, but we’re approaching the world in similar ways. Also, many other volume funds trade across asset classes; we focus solely on the equity derivative space given this is our core area of expertise.
MT: What was the transition from Goldman Sachs to being a startup like?
JW: We were really fortunate to have a fantastic strategic investor who seeded our business and helped us think through the process of leaving a 30,000 person organization to start a three-person company, at the time. We learned how to create a business. This was an opportunity we couldn’t pass up, even if we had great jobs at one of the best banks in the world.
MT: What is your culture like?
JW: The team is the most important thing that we have. We have a very fun, yet serious office. Everyone knows their role. We usually leverage our existing network when looking for additional talent. We want to meet everyone and hear a variety of diverse ideas. But our internal dynamic and not disrupting the team environment are important in managing our success. We certainly don’t want to make our office very large. We’re in a shared office space, and I love that about us. It’s still a very entrepreneurial environment and we’ve been doing it almost four years now.