Inside the Secret World of Prop Traders | Noel Smith of Convex Asset Management
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Hey everyone, Jack Farley here. What you're about to hear is a brand new show here on the Monetary Matters Network called Other People's Money. Hosted by my friend and business partner, Max Weethy, Other People's Money is the premier podcast about the business side of the fund management industry. Do us a favor and search for Other People's Money with Max Weethy and subscribe to that podcast.

Before we get started, I just want to do a quick disclaimer that nothing we say here is marketing or advertising for Convex Asset Management or any of their funds or products. Everything is meant to be educational and informative about the fund management industry. Welcome to another edition of Other People's Money. I am joined today by Noel Smith, the CIO and founder of Convex Asset Management. Noel, thank you so much for being here today. Thanks for having me.

All right. Well, I'm very excited to discuss two different types of money management. The show, obviously, it's called Other People's Money. We're very focused on fund management and the idea of managing other people's money. But you have a ton of experience on the prop side.

of trading, which implies that it is not other people's money. It is often other people's money if you're working for a prop firm. So there is some aspect of that, but it is very different than managing money from the fund side. I know that you started your career really on the prop side. So why don't we go back and explain to people what exactly proprietary trading is and how it differs from the traditional fund management industry?

So prop trading is just kind of doing what you want. Think, you know, you have your own Schwab account and nobody's really going to tell you if you want to buy Tesla or Tesla calls or short Tesla, short Tesla calls, whatever. You can kind of do whatever you want. So prop

Running my own money is really what I did for almost my entire life up until recently. Prop firms. I mean, there are a lot of prop firms employ a bunch of people. So you are running somebody's money still. When you were a prop trader, did you employ other traders? Did you have splits with them?

Yeah. So I'll get some context and background so that it kind of flows and makes sense. I started out in 1996 on the floor of the CBOE. I was one of those guys that you see in a wacky jacket standing on the trading floor. And the money that came from that was initially supplied by my business partner. He had, you know, not a lot of money, but some. And I had none. So he asked me to kind of come around and, you know, he and I started this arm.

And then as we had some profits, we started to back other guys. So think of it as like, you know, the Max and Noel firm, right? We each put in a thousand dollars and then we run into Bob and Bob trades something else that we like. We think Bob can make money too. So we decided to back Bob and, you know, that's now we're, you know, a three person firm, you know, your money, my money, but Bob didn't have any money. So he just said, Hey, listen, I want to trade, you know, bonds.

And, you know, so we, we break off some money for Bob to do his thing too. So now it's still our money. We're not looking for outside money. We don't even want outside money because that invites a whole nother, you know, hornet's nest of problems. But we are in the business of backing other people. And I've backed out of north of a hundred guys, not by sure by how many, maybe it's 101, maybe it's 110. But I've had guys really in all the major products over the years, you know, at various exchanges, really in every options pit in Chicago,

a board of trade, which is bonds. We have Euro dollars, which is the, you know, which is now SOFR, which is at the Merck in Chicago, the Comex, the Nymex, the Amex, kind of all over. So I've had guys representing my capital really in all of those pits or those organizations at one point or another.

I'm sure there are a bunch of people listening to the show who would love to get backed by somebody to go take risk and trade. How are you finding these people? Are they people who are maybe working for another prop? Like, how does one get into that world of being backed?

I don't know what the best path is nowadays, but back then I worked in a building called One Financial Place. So as you can use in your imagination, it's basically a 45 story tower with nothing but hedge funds, prop trading firms, market making firms, that kind of thing. So eventually you just run into somebody who's like, "Hey, I trade corn at three in the morning for Citadel, or I work for Susquehanna or whatever else." You just get to know people. And then

as people either quit because of whatever reasons or they get fired for whatever different reasons. You just say, you know, Hey, listen, there's somebody else we know just like, you know, how do you find a new person to work for you? You know, my cousin knows a guy and that's kind of how it works. And like anything we did recruit out of college. We recruited out of, you know, top tier schools, which actually had less success than,

secondary tier schools. Like we had really good success out of University of Illinois, University of Michigan. When it came to some of the Ivy League schools, we had less success and we built traders that way when we couldn't, you know, buy traders the other more traditional way.

What is the starter capital when you're bringing somebody in? And I'm sure it differs between taking somebody out of school who maybe has to be taught and learn on the job versus somebody who, like you said, you know, you've met in one financial place and you know that they trade and they have a product that they've been trading for years. How much capital are people getting? And what are the economics like?

So the economics of the capital, the capital is different when it's your own money, because it's not about like, here is a pile of money. It's yours. No, don't blow it up. It's more like, okay, we have this pile of money. We're going to apportion some of that risk to you. So risk capital is not the same as notional capital. So say you have a, you know, a hundred million dollars in your account and you want to give $1 million to Bob.

Well, you don't actually take a million dollars and put it in Bob's name. What you do is say, okay, Bob, you know, you can, you know, a portion, a million dollars of risk. And there's a lot of different ways you can do that. Like say, for instance, you know, you have, you want to be long Apple. Well, do you go out and buy a million dollars worth of Apple? Do you go out and buy a million dollars worth of Apple calls? That notional, it's like $50 million, right? Those two things are totally different.

So, um, and that's kind of as a conversation that you have internally, which is what do you think of the merits of the trade? And, you know, what is your track record in being long Apple calls versus being long Apple? And, um, so you're really looking at it as a function of what can they lose? Cause the, the, the gains kind of take care of themselves, but you, what you really want to do as a backer is figure out, okay, how does this guy blow up? And on some totally random, you know, sequence of events where you're going to end up losing way more than your million dollars,

in this example. So, you know, say for instance, you know, you think that the most Bob can lose is a million, but now he's, you know, he's down 20 million bucks. That happens. So that's what you really have to, you know, be aware of. And that's really a more accurate way of thinking about it. And the second part of your question is like, how does the breakdown work? Typically it's a split. So you start out with something like, you know, okay,

Again, we're going with hypotheticals, but, um, you know, say here's a million dollars, Bob, uh, of risk capital. And if you make 500,000, then, you know, you get to keep 30, 35%. And then if you make another, you know, 500,000, now you're at a million dollars total net profit. No, we'll bump you to 50%. And then if you end up being, you know, three or four or $5 million in, you know, total gross profits, then we'll give you some kind of a higher split. And then there's usually, um, an understanding that if you get to the higher splits,

You keep some capital in your account so that, you know, if things do go sideways, you know, you just don't rip through all of firm capital right away. By the time that somebody is in that position, they're usually a trusted asset. And even if they do lose money, you kind of know the reasonings why. And if it is smart judgment or good trades that got you there, you might even add.

are you thinking in percents? Are you thinking in dollars? Obviously different strategies have different capacity levels. You know, you can make something, somebody might be able to make a hundred percent on a small amount of money versus, Hey, this guy can consistently make 10, 20% on a lot, a lot of money. Like when you are thinking about backing people, is it, is it all about the dollars? In the prop space? Nobody cares about your 10%. Okay. That's for T-bills. Um,

What you're looking at is the risk capital. In other words, how much you're going to lose, how much you're going to make in any one given time increment. And, you know, what is this going to do for me? So typically, you know, if going back with our million dollar example, the idea that you buy a million dollars worth of Apple calls is more likely than just spending a million dollars on Apple. You know, those two things, you know, if Apple goes up 10%, you make your hundred grand. If, you know, Apple calls go up 10%, you might make, you know, another million or whatever.

So what you're really looking at is that gearing that comes with

lack of scalability sometimes, you know, that can be quite useful. And, you know, you're looking to capture edges where really big firms can't really deploy those types of edges. You know, if you're running Millennium and, you know, you have, you know, $500 million doesn't even move the needle for you. You know, if you make $300 million in profit, you know, you get an attaboy, but does it really move the needle for Millennium? I mean, barely. So why are you goofing around with these small little trades, right? Like I'm going to sell, you know, 300 Tesla puts.

So it doesn't matter. So you have to start to think big picture. But when you're running a, I call it sub $100 million of prop capital, you know, making extra two, $3 million. Yeah, that's great. Because if you have $100 million of capital, you know, in any one given time, you're probably only risking 20 or 30 or $40 million. So, you know, to make $3 million in any one given trade, that's a fine day.

Yeah. And are you pulling, obviously, if you're doing these smaller capacity constrained strategies, is it you're pulling money out every year, you kind of run up to a level and then you scale it back down? How does that work?

I don't think there is any one answer. You know, I kept probably 95% of my net worth, probably more, in the firm for years. You know, I didn't pay myself for, you know, two, three years for some times. And, you know, also that firm capital, like we did other things with it. We invested in other companies. We got involved in high frequency trading. I've done probably, I don't know, 11, 12, 13 different VC ideas, 10 of which have gone to zero.

So, you know, you have all kinds of things, you know, when you have some success and people know about it, you know, you get people dive bombing you out of the blue. Hey, listen, I want to go drill an oil well in Oklahoma. All right, great. Well, what's the merits of the trade? So, you know, those types of opportunities present themselves to you. You've moved on from the prop world, at least in some capacity, and now you have Convex and Convex manages other people's money. What was it?

uh that made you decide to move away from this prop world into the world of opi you know it's funny there's specific stories i met a guy who wanted to launch a hedge fund years ago i saw friends with the guy and he launched a hedge fund and i'm like good luck to you man and you know when he first started doing it he was like struggling he couldn't really make any money and

About a half a dozen years later, he did really, really, really well. And he's doing fantastic right now. Just unbelievable. And it wasn't so much, he was willing to sacrifice a way larger chunk of time to get to scale than he thought or I thought. It really is the idea of, is it better to make X amount and you keep all of the money? Or is it better to make the percentage of 50X the money?

Well, in theory, the 50 X the money, the hard part is getting 50 X the money. So that is the eternal trade. You want to do something at scale, does your strategy scale? So, you know, going back to like, why would I do this? And part of the reason even that this interview exists right now is because my other partners, when we were prompt trading or even high frequency trading, they didn't, they issued the media. We all issued the media. We didn't want to talk to anybody and it was not in any of our best interest. It was kind of douchey and self-aggrandizing and nobody wanted to do it.

And so that was just part of our business. But I thought that if I ran a hedge fund and I was asked questions publicly by the media, the press, whatever, I could answer them.

And I would present at least okay. And I thought I could do that part of the job. I thought the money raising part would be easier than what it is. And I thought that I could scale. So all of those things kind of combined. And with some of the people that I've known that have launched hedge funds that have been successful doing it, I thought, well, you know, I can do that. And then I know other hedge funds that I feel like they don't even do anything all that spectacular. Then they make, you know, 8% a year. I'm like, yeah, I can do better than that. I can build a better mousetrap.

So it was really kind of common sense, which is like, I think I can do it. And I mean, that's it. I think I can do it. I think I can be successful doing this. And, you know, the jury is still out with it. Now that'll end up being the case.

How has asset gathering gone and what do the people who are interested in some of these more prop-like strategies look like? Are they people from the prop world who've done very well, who see it similarly to backing a trader? Or are these people who don't have access to that prop world who you provide an avenue to get into some of these strategies that are not as common in the hedge fund world?

So capital raising has gone way harder than I thought it would have been. And, you know, whenever somebody, you know, if I'm listening to this podcast in the future and someone says to me, hey man, I want to launch a hedge fund. I am one of those guys that almost always like, you know, go for it. I want to become a movie director. Go for it. I want to become a rock star. Go for it. You know, I'm never one of these guys that says, hey, it's hard to become a rock star. You know, if you think you could play guitar better than, you know, Jimmy Page or whatever, then, you know, that's what you got to do. You know, there is a nexus of preparedness,

luck, timing, you know, all of these things that, you know, we really need to have kind of come together. And it is more difficult than I ever would have gambled for. So my returns as a prop trader were fantastic, you know, by any measure. And so I thought I could map that to capital raising wrong. I was, it's much harder and, you know, the crop returns aren't really applicable. So there's that. And, um,

The people that you're talking to, people that we've responded the best with are the highest tranche of sophistication. We resonate the best with market makers, top traders, guys that kind of have my same background because they can identify whether or not we're full of crap.

instantly. Just no nonsense. You know, you can cut through. If you've been doing something for 30 years, the idea that somebody is going to get in front of you and BS their way through a conversation is asymptotically approaching zero. It's just not going to happen. You know, and if you start to, you know, get some red flags in the conversation, you drill a little deeper and you figure out, okay, this guy really know what he's talking about. What happens if this happens? What happens if that happens?

And you go through all these different combinations of scenarios where you can make or lose money. And you can figure this out really, really swiftly. So we tend to do the best with the hardest questions in the wackiest scenarios. Like, you know, how do you make money when, you know, Mercury is in retrograde and there's a spaceship flying overhead? Well, this is how we lose money. Great. And also, I think that the prop trading community really respects people that cut to the chase and say, okay, this is how we lose money.

And if somebody tells you they can't lose money, they are lying. It just doesn't exist. And so we really do click best with like the single highest tranche of investors. We do poorest with people that are the exact opposite of that. You know, a quasi retail investor

type of investor or a family office that, you know, made money selling drywall in Tulsa. And, you know, they have, you know, a billion dollars now and they want to get into the marketplace. Well, we get in front of them, explain what we do. And they're just like,

I have no idea what you're talking about. That makes no sense to me. And it's not that they don't believe us. It's just that they're not equipped to really ask the questions or understand the answers. It's not because I know anything more about drywall. It's not even being like, you know, we're so smart or they're so dumb. It's just like, you know, they're outside of their comfort zone and we typically don't get allocations from firms like that. And so usually the more sophisticated, the better, which I think frankly is a weakness of our business. And maybe my messaging.

So I guess, is there any any time you've been able to cross that chasm with somebody who's perhaps a little bit more retail?

See, that's part of the reason I do podcasts. It's to build credibility. So, you know, if you, if somebody doesn't know you, like I come out of the prop community in Chicago. So, you know, people that know me in Chicago or works for me in Chicago, like, yeah, those guys did really well. Other than those people, nobody has any idea who I am. So, you know, you get in front of some guy and you're like, you know, some, again, drywall guy in Tulsa. And you say, okay, and I made X thousand percent. He's like, did you really? That doesn't sound true to me.

And then you kind of go through that conversation and you pull on that thread. So what you're really trying to do is build credibility. You show the numbers. Well, the numbers are just table steps, right? Everybody shows their numbers. And then you have to just be able to build a rapport with these people. And I guess one of the things that

I was most wrong about because I've hired people that aren't even really like, I don't really care if I like you. That's not relevant to our business. So if you come to me and you're a total weirdo and you want me to back you,

I don't care if you're a weirdo. My ex-partner, he was like, you know, he had a lisp, he had long hair. You met this guy at a restaurant. You'd be like, what? Who is this guy? And he actually was a really good, really, you know, smart guy, good trader, made a ton of money. But it's not a personality contest. And I thought that the capital raising business would be more similar to that. It's not. It almost is a popularity contest. You know, you have to be able to interface with these people and build a rapport with

that really isn't about the mirror of the trade. In other words, if say you were, you know, you're up, you know, 10% and someone else is up 12%, does that really matter?

Not if you're cool. They'll take your 10% as opposed to the superior 12%. Not everybody, but you have to, it's like dating, you know, not everybody's the same. Some girls want to play golf. Some girls want to, you know, shoot guns. Some girls want to, you know, swim in the river. I don't know. And, you know, you have to be able to adapt each one of those types of scenarios. And it is much more about relationships and way less about the merit of the trade than I ever would have reasonably guessed.

And so, you know, obviously you're doing the podcast. I know you do the EQ Derivatives conference. I'm sure there's plenty of people who are trying to get their name out there. How do you get to be a speaker at a conference like that? And, you know, is that a good place for people who are trying to to build relationships with people?

I have never asked to do anything. Like even this podcast, you know, you guys said, Hey, you want to do a podcast? I said, sure. All of my podcasts have been like that. Um, EQ derivatives is one of the conferences I've spoken at. And those dudes are just like, Hey, they're not, they're dudes, they're female. But, um, you know, Hey, you know, we have this thing going on, you know, do you want to come talk about whatever it is you talk about at our thing? And I'm like, okay, sure. You know, and I just kind of show up. I do my little speech and go around. I would say that,

I've raised, well, I shouldn't say, I would say I have raised zero money from those types of conferences. I think it does raise your credibility, but can you cash credibility checks? Nope. Is it a necessary part of the business?

It's tough to say. I think if you don't do those types of things, you need to have something else that makes up for that deficit so that people can identify you as being a real entity in the space. Are you credible? Are you accountable? Do you do what you say you're going to do and those types of things? It is easier if you're willing to go on stage, speak to a crowd of professionals and be scrutinized by them writ large.

So I think that does make things a little bit easier, which is why I do it. But is it a path to, you know, raising AUM? Not for me, it hasn't been. You talked about how the returns don't map from Brock, but do the strategies map? Are you able to run similar strategies? Maybe the scale of it makes it so that the returns aren't the same, but the still the same type of trades, you know, intellectually.

Yeah, totally. So the whole point of my firm is doing exactly that. What we're doing is we're taking best practices from prop trading, doing those trades that investors never really see

in a normal hedge fund and we're putting them in an investable package. So that is really our sales pitch, our edge case. We're doing things that other people don't do and we're giving you alpha as a result of these things and you probably have never seen it. And the feedback I've had almost universally is that, yeah, we don't see this. You guys really are unique. Really nobody has ever said, oh, there's 10 other dudes doing what you do. That's never once happened to me.

I call it the hedge fund category problem. Like if you go and you're reporting your returns to like Prequin or whoever, if you're long short and you're low net, like you check the box, are long short, we're low net, you fit into this nice category. And then if some allocator is using Prequin to source a manager and they're looking to write a check for long short, you know, it's a big top of funnel. Like how do you deal with the fact that you don't fit neatly into a category that's

Not that great because we are...

CAG is a volatility fund, which is true and also untrue. So whenever you're different, it's good and it's also bad. You know, and if you're like, say you're a music industry executive, you know, in 1968, you want every band that sounds like the Beatles because that's what's making money right now. But what's really going to make money in the future isn't probably the Beatles. Nothing against the Beatles. Rolling Stone, yeah. Even the Stones are, you know, they're not that different.

than the Beatles. I mean, Led Zeppelin's a little different or Pink Floyd, you know, they're a little bit more psychedelic. But my point is, is that in order to be successful in the future, you can't just be like everybody else.

But if you're not like everybody else, people don't really understand it because by definition of that, you are innovating on some new level. And, you know, we're not a long short fund. I think that being a long short fund would be very easy because I can say I am a long short fund and they're like, OK, I know what you do, but there are 7000 other long short funds. So now how do you differentiate yourself from those 7000 people in your peer group?

Not so simple. So when we use options and a lot of other things to get our alpha. So sometimes that's a real benefit. And other times it's a detriment. It's a detriment because people don't understand it, but it's a benefit because nobody else is doing what we're doing.

I got a chance to look at the deck. You've got sort of like five core strategies that you have in this nice little Venn diagram. At the top, you've got Vol ARB and Vol Risk Premium. Maybe you could explain a little bit like what is Vol ARB? What is Volatility Risk Premium? And why do you think that what you do doesn't necessarily qualify you as a volatility fund?

Again, there's like five questions in there. We could spend an hour on each one of them. So let's answer them in order. What is well ARB? Well, well is volatility. Okay. ARB is the idea that you're simultaneously buying and selling the same thing at the same time and you're making an edge. That's not exactly true. We're not doing that. We are doing things that are substantially similar, like saying, you know, Coke and Pepsi, right? They're substantially similar, but they're not the same thing.

So what we're trying to do in Volarb is we're trying to capture edges and things that are similar by a certain percentage so that we can make money on both sides of the trade. And Volrisk Premium is a totally different thing. What we're really doing there is we're harvesting the risk premium that is embedded in options

over time. And it's a way to make money when there's nothing else going on. So, you know, the S&P 500 has had a really good 2024. What happens if, you know, we're in a Japan lost decade for the next 10 years and the market goes sideways for 10 years? Do we need the market to go up to make money? No. And, you know, those questions are answered within our deck, really, which is, you know, we try to have a case for how we can make money, market up, market down, market sideways. And

The other question you had in there, which is like, how do you do this stuff? Well, sometimes if you want to be long Apple calls, I'll stick with Apple because everybody knows what it is. Is it better to be long the calls, short the puts, short the risky, long the risky or long the stock? And sometimes you want to be long the stock, not because you love Apple stock or have any opinion about the iPhone.

But because you think it's going to go up, but because of the options, not because of the iPhone. And that's an interesting distinction because volatility to me, like people ask me, you know, why do you trade volatility? Well, volatility is one of the very few things that is forward looking. You know, it is a future market collective opinion about where things are going to go.

Well, Apple price does that a little bit. The price of Apple stock, that is. Apple earnings definitely does not do that. You know, it is a snapshot of like, you know, what happened last quarter or what's been going on in the last 10 consecutive quarters. So it is a way to

Be more accurate with market calls. And those calls can be, again, they can be expressed in a multitude of different ways. And so we're using options as a way to make investable decisions that aren't always in the actual options themselves. So you think that the pricing of options is more predictive of future price movements than, say, analyst estimates?

100 million percent, yes. There's no way you can sit there and watch CNBC for 10 years and do what the analysts tell you. And then you go stand on the floor of the CBOE and deal with the Goldman broker, the Morgan broker, the whoever broker, see their flow and not have better trades. That is just impossible.

The information you get from the options flow is way better than the analysts and nothing gets analysts. I think that, you know, they're very, I have a very hard job, but the quality of information that comes from the marketplace is way better. And do you think that it's these people know something that these analysts don't know, or just the sort of like wisdom of crowds collected? Sometimes, sometimes that's why I don't trade biotech stocks anymore because I've been smoked in biotech stocks way too many times. Um,

That's the reason, right? Because, you know, some guy who's never trading options comes in and buys 10,000 out of the money calls. Next thing you know, the stock's up 500%. That's a real thing. You know, not to get dark, but, you know, we were short a bunch of airline puts going into September 11th, 2001. I had no idea September 11th, 2001 was going to happen. And we sold a lot of airline puts. And it almost put us out of business.

So do I think the quality of the information is superior in the options market than the analyst community that is almost always paid for by the people that are benefiting from it? I absolutely think that. And anybody who says otherwise, we need to argue because that's just not factual.

And so like using that 9-11 example, I mean, I think with hindsight, it's become clear that they were that the people who knew that this attack was going to take place were betting in the options market against the airlines. And so you as somebody who didn't know this was happening, you're looking at the pricing of these options and saying, this just doesn't look right. Like there's some heaviness in the options market. And that's why you were on the other side of it.

Of course. I was a market maker and we were making markets in UAL, American Airlines, all the airlines at that time. And say that for instance, the volatility of the athlete money put is normally 35. The numbers don't really matter. Then you sell,

a 1% position at 35 volatility. Then they come back, you know, like a day or two later and they're paying 42 volatility. You sell some more. Then they're paying 53 volatility. You sell some more. Next thing you know, they're paying 80 volatility. You're like, whoa, I know these guys are going to miss earnings. So, but they're buying what's in all of them. So they're not going to miss earnings across the board. Is it oil prices? You know, we start thinking about all of these things.

Now, if you remember in 2001, the market has already kind of come out of the tech bubble and starting to go down. The market was already going down. Enron happened. So a lot of volatility was already pretty high. So the idea that someone would buy puts in something and pay a high vol was like kind of, you know, in fair play at that time. And so we had sold, you know, hundreds of thousands of these things. And like I said, 9-11 happened. You know, if the market actually did open that day, which it did not,

you know, we would have been out of business for sure. Not only that, but here's a little bit of trivia. I was in the World Trade Center the day before, which is just extra bananas. I was invited out by Goldman to go to the U.S. Open and I had lunch with somebody. It was called Windows of the World at the top of the World Trade Center. And then I flew back to Chicago that day. Next thing you know, you know, there was a fire going

at the World Trade Center and everything else we know. But that is definitely a real thing, getting back to the point, which is the options market is probably the first stop for nefarious information

And then if you can figure out what's nefarious versus what's hedging information. Now that's an extreme example of nefarious. The other side of that might be, you know, some pension fund that has a zillion shares of Microsoft in their book. And you know, they've had a good year. They don't want to get wrecked. So they go out and buy a bunch of puts. Is that a good trade? Yeah, that's a great trade. And if you can figure out the difference in the caliber of information, what is nefarious and what is just a hedging trade? Well, that's a business.

All right. And so how do you determine when you talk about biotech? Like, obviously, there's a lot of approvals, regulatory approvals and testing that's going on to determine whether this biotech stock, which are usually kind of like a binary pricing, like is the drug or the machine or whatever it is that they're building, is it going to work? Clearly, there's some areas where it's very difficult to determine what's nefarious.

And they're wrong a lot, which is why this biotechs are funny. So, you know, think of it as it's actually called bimodal. So you have your normal distribution, right? And then in a biotech stock, you're going to take two of these standard deviation distributions and kind of scoot them different, you know, parameters, right?

So if say XYZ biotech stock is at $100, well, it's going to go to 200 or it's going to go to two. And you can kind of figure both of those out. And the marketplace is pretty clever and the marketplace knows that. But the timing a lot of times is hard. So Evol will get bid up into some kind of an announcement. Then the announcement will be delayed. And then a straddle that was trading for

$40 with the stock at a hundred goes to like four, just not trading at 102. And it's like maddening for those people to buy a bunch of volatility and expectations for some big event that just fizzles. And that happens a lot too. So that's what kind of coaxes you into that. You know, you see some of these trades happening. Oh man, there's all kinds of edge in this situation. But then, you know, once every fifth or I guess every seventh trade, well,

wham, you know, the stock does go to 200. Oh shit. Now I just got wrecked on this trade. And then, you know, that's, that's the deal, right? You live by the sword, you die by the sword.

How do you really determine whether something is hedging or nefarious? I mean, is it a knowledge of who the participants are in the marketplace? Does the flow look different? Is it just a hunch? Well, that's the art of our business, right? If it was on the screen, everybody could see it. If it was in the data, then every program would scrape it. So knowing how to figure out the quality of the paper

is a skill. It is a human skill that maybe will, you know, be sussed out by AI or whatever. But for now, it's still something that is, you know, a human skill.

I want to talk a little bit about how returns scale. So you mentioned that you can't generate these like prop level returns when you're running, you know, larger pools of capital with, with other people's money. Where, where is the breakdown? Like at what is, at what level of AUM do the returns start to degrade? And then what is the point where it starts to look unattractive even to outside money? The money that is made in prop

Anybody listening to this who's not in the business will believe. The Sharper ratios are out of this world.

The consistency of profit, the risks that are taken and the profitability, you know, like Jane Street, they just, this is public. They just put out, you know, they made $14 billion this year. Okay. Well, how many employees do they have? You know, how many guys are actually making that kind of money? So do you think about, you know, what's happening at like Citadel Securities and Susquehanna or Virtue or Jane Street? There's just an absurd amount of money being made by relatively few people.

And again, the Sharpe ratios, you know, if you are in the hedge fund business and you have like a one and a half Sharpe, you're kind of a stud. You know, there are high frequency firms that have a Sharpe ratio of 20. Those numbers are just so far out of range that most people are used to ever hearing about. They don't even know that they exist. It's like having an NBA basketball game where the score is like 2000 to four. It's just, it's just doesn't sound real.

They exist. They exist for a variety of reasons, but they don't scale. And to answer the question, the number is something around $100 million before things really start to taper off. It depends on how. Are you trading futures? Are you trading options? Are you trading single name equities? Are you trading them in latency arbitrage? How big can you scale and why? Well, there is innumerable answers to that question, but you usually aren't doing something with a billion dollars that's going to have a 10 sharp.

If you're doing high frequency trading, it's usually sub $100 million. Depending on, you know, we are talking about deployed capital because you're in the future space or in something that has a lot of leverage. And, you know, the idea that you can make $500 million on $100 million is fully in range.

But the idea that, you know, if you're running Millennium and you have $69 billion that you can make $69 billion, you're almost certainly not. It is, I don't even know how you would do that. You gave me $69 billion today and said, you know, make $30 billion. I don't know, put a bunch of T-bills and buy some Apple. I don't know. It's just a totally different game. And the shape of that return and the scale of it is just, it has nothing to do with each other. It's totally different.

There is a guy on Twitter, Gabby, who talked about, like, would you rather have a two sharp on a billion or a 15 sharp on like 15 million? I think was the question. Like, what do you think about that question? If it's all my money, then again, a sharp ratio implies no drawdowns. Right. Or low volatility and high beating of the markets doesn't really speak to the RIPs.

and the scalability. So knowing what I know, I asked you the question, which is I'd rather have a two sharp on a billion. Um, because I, the chance that I can do that with 2 billion is pretty high. And the chance I'm getting, you know, a one and a half or 150 basis points G on it's pretty high. Um, and also a, you know, a double digit sharp strategy is going to have alpha den degradation probably. Right.

So if you could convince me that there's no degradation of your alpha over the next 30 years, all right, that's different, I guess. That's a really great trick. But the market is unbelievably clever at figuring out what it is you're doing and taking that money from you.

Well, yeah, let's get into degradation a little bit. I'm sure strategies that you used when you started out in this business in the late 90s don't exist today. And you've had to develop new strategies and things that maybe you did even just a few years ago. You can't can't really do anymore. How fast does this happen? Are there things that are evergreen that you think are going to be around, you know, till till the day the sun goes out?

So if, you know, nobody's ever asked me this, but I'll give it an answer to the unasked question, which is like, what's my real alpha? My real alpha is,

The nexus of creativity, experience, and science. And that creativity, I'm a pretty creative person just by genetic nature, allows me to see or connect dots that maybe others don't see. I know a good friend of mine who works at a globally recognized firm is genetically way smarter than me, but his ability to be creative is way lower than mine. So would I rather have him be my employee or would I rather back him? I'd say I'd have him be my employee.

Because he is extremely good at doing good things with what is known. He is not that good at seeing the unknown. You know, if you asked him to decorate a vacant house, he'd be like, I'll hire a decorator. You know, because he can't see like purple goes with yellow or whatever. And piecing together

what's changing and how your alpha will degrade with time and coming up with new ideas or iterative tweaks on your alpha to me really is the job. So things that I used to trade got put on the shelf for a while. Then they came back, right? Like I trade dispersion and I traded dispersion, you know, 20 years ago. And then the way I do it now, is it fully different than, but is it the 20 years ago? No, not really. Is it different? Yes, it is different.

And I tweaked it and I iterated on it, you know, hundreds of times. So it's a substantially different trade, but the core thesis is the same. And, you know, even that trade ebbs and flows with time. Sometimes it does really well and other times nothing happens. But that also speaks to like, why did I launch a hedge fund? Because if you're just running a dispersion desk at Citadel, well, if dispersion dries up, your trade dries up and so does your money. So that's kind of the problem.

But if you have multiple trades in your little toolbox, then you can kind of apportion capital where you think the opportunity set is superior. And you use this friend of yours, you know, hypothetically, like as far as personality types go, like is that route of going to a dispersion desk, say at Citadel, like the right move for some people? I'm sure there's a lot of people listening to this who want to be a trader, want to start a fund. Like, is that the right way for a lot of people to go? For most people.

Yeah. Launching a hedge fund, I know this is about other people's money, isn't easy. It's way harder than I thought. And I came from an extremely good background. Well, I would say the second best background to launch a hedge fund. The best background is you go work for a giant hedge fund. You want to go

You'll hang out your own shingle and they break off a billion dollars for you and send you on your merry way. And they take some of the economics. That's the best way to do things. Or the best way is just be born into money. That's the best way, right? You just have this giant pile of money that your dad gives you or your mom gives you and poof, you're rich. Yeah, the family office route. So that's the easiest way.

Um, the second easiest way is to spin out of something else. And probably the third easiest way is to come from kind of my background, which is like, you know, you worked in the sausage factory and you did all the stuff that is needed to understand how the sausage is made. And then you can reasonably go out and, you know, sell your own sausages. Yeah. Um,

But I mean, there are a lot of people who still do that, who also fail at launching hedge fund. So there, I mean, just because you've worked in the sausage factory doesn't mean you have the right temperament for it or you understand. I mean, there's so many people, this belief that like, if you have alpha, if you can do that over time, that sort of like, if you build it, they will come. Yeah. And I think that that is like totally wrong. So I'd just be interested in like,

Did you believe that when you entered? Like, all I have to do is put up the numbers and people will find me. And yeah. Yeah. I was totally wrong. So, I mean, you probably have interviewed a few people that had a better track record trading options on a product level. We did great. Congratulations to me, right? It's not where I'm going with this. So I thought that I could use that performance and just like hang out a shingle and everyone like, oh my God, this guy's amazing. And just throw a bunch of money at me. Totally wrong. It is.

a spurious relationship with your success as a hedge fund. I know people that have way less performance that have raised, you know, multiple billions. And I'm like, really? How? I meet people all the time that run billions of dollars that I think don't have that much IP at all. And,

tough, right? You just, there is no one path. If there was, it's just like a trade, right? If there was any one path, everybody would arm it out because there's all these ways. Like, how do you find a wife? How do you find a husband? There is no way, right? You know, do you meet them through church? Do you meet them, you know, at the, you know, the club or do you meet them in a hike? You know, there's so many ways you can meet somebody that you click with. And even if you meet them, maybe it's still not a fit. It's, it's the same. And I think that I don't want to discourage people from the

If you don't already have some money, we have a plan and then have a network of people that you can raise with. It's going to be really hard because, you know, you have to bear in mind that the people that are allocating, they're like, you know, the most beautiful woman in the bar, every single guy in the bar wants to talk to her. Right. So she just says nothing but options. And she's like, next, what's your deal, guy? Well, you know, I'm a heart surgeon and a rocket scientist. Boring. Next.

It's like that, you know, it's just, it's hard. And if you don't have like every single box checked, you know, you're, you're probably not going to go home with a prom queen.

Yeah. And so, I mean, do you, if you had to say what's more important, relationships, likability or returns, like what's more important? That order, relationships, likability and returns. They're in that order. Now what's most important to least important. And I fallaciously thought it was inverted. I thought that the returns would speak for themselves. And then, you know, if people thought I was a quirky weirdo or I speak too fast, which I do, that they would overlook that. I thought that

You know, much like when I would back people, I would say to them, okay, you know, what's the merits of your trade? I don't really care if you're six foot tall, two feet tall, eight feet wide, eight inches wide. I don't care. I want to know about the merits of, you know, the business relationship that we have. And I mistakenly thought that that would be how it would be for me raising money.

And it's not like that. You know, you really have to get to know people. The gestation period for, you know, introduction to actual execution could be years. You know, and who's going to feed your family for these years while these dudes are thinking about it? Or maybe an allocator wants to give you some money, but you want to buy a boat instead. So now you've got all this money mentally spent in your head and poof, this guy has a boat and you have no money. Happens all the time.

Obviously, it differs, but what would you say is the average from an introduction or somebody coming, filling out a form on your website or sending you an email to your info at Convex or whatever it is to getting a check? What is that sales cycle like? Because I think so many people come in and they're like, all right, show me the results of your marketing strategy or whatever it is. How can we have any checks? It's been three months.

So for, for smaller investors say, you know, let's say it's you, you know, you know, like, you know, it's max. I went, I want to put in, you know, 300 grand. I've got $30 billion of net worth. I'm going to put in 300 grand into your fund. It's, you know, it's, it's basically a nonsensical amount of money to, to you and me. It doesn't really matter, but it's, you know, it's a way to commence business. Those things can happen somewhat swiftly. Um, but the real checks that actually have some kind of an impact on the bottom line take no less than a year, probably more like two.

you know, and now if you're talking to an institution and you have to go through investment committees, they have to align, there's gotta be just some level of luck. They have to have been burned by something else, but you, you've convinced them that, you know, you're not gonna burn them on that same idea or you're so different that it's gonna end up being a, um, it's a different part of their bottom line. Cuz you're almost never talking to the person that made the money. You're talking to a representative, you know, many levels down sometimes of a pile of money that,

Their only real concern is getting fired or you embarrassing them.

I, everybody wants to give money to millennium or Citadel because nobody's gonna get fired for, you know, giving Ken Griffin more money. You can't cause he's closed. But you know, the idea that if Ken Griffin gets chopped in half, well, you know, half the pension funds in the country have already been chopped in half as well. You're like, well, that's just how it goes. Right. Um, they're, they're the smartest in that there is. And if they got chopped in half, then, you know, that's just, you know, what are you gonna do versus you give money to, uh, you know, a small hedge fund

and they go down 10%. You're like, wow, how did these guys get, why did you give them any money at all? You know, they're down 10% now and now it's going to hurt our, you know, our balance sheet by three bips. You know, those, that's the way it's looked at. And it's not as logical as you think. And even if you make say 60% in a given year, is that good news? No, that's volatility. So that's too much. So it's like, you know, there's all these counterintuitive things. You know, you've got to be very middle of the fairway with a lot of these allocators. And, and,

You really can't be too different, but not too similar. And that part is really as an art.

Yeah. And I guess how much of it is solving a known problem for them versus showing them something new? Like when people come and they write a check for you, how often is it they've had a problem with a prior allocation and you are able to explain how you solve that problem for them versus teaching them about this prop world and the way you trade? You just don't really know. All you can really do is speak to what it is you do. You know, but

When I talk to potential investors, you know, I do ask them like, what else is in the book? What else is working for you? What else is not working for you? Because to me, those are sensible questions. You know, you want to buy a car. Well, what do you want? You want to pick up truck? You want a Ferrari? They do different things. You know, we try to explain that, you know, we do what we do, but we also have a pretty good understanding of the breadth of the marketplace. And, you know, why would you want to give money to me versus Citadel? Right. Yeah. I mean,

You know, we try to have those answers pre-populated and, you know, those questions pre-populated with answers. So, you know, there is no one way. I know these answers are like, you know, a little bit nebulous and unclear, but, you know, the problem is that there is no one answer. Again, and if there was an answer, you would already know it because it'd be on Twitter or something else. And then everybody would just do that same thing.

You know, if the, if the flow of operations was watch a hedge fund, go talk to, you know, Joe Smith because he gives money to hedge funds. Well, what happens? Joe Smith runs out of money. You know, maybe it's going really well. I don't mean running out of money in terms of like he lost it all. I mean, just, he just is allocated it all right now that that source is, you know, it could be CalPERS. It could be OMERS, whatever that sources is now dried up. Right. And then you have to kind of always move around. Well, what's the best stock to own? NVIDIA. Okay, great.

But, you know, at some point that's going to change and it has to come up with something new. Maybe it's, you know, you're selling qubits or something. I don't know. Yeah. So I want to talk about like what the touch points look like. I love to hear that you asked a lot of questions. So somebody has come in, you've developed a relationship, you know, the clock has started, whether it's one year, whether it's two years. How often are you touching base with people? And are you talking about yourself? Are you asking questions about them? What does a touch point look like with a lead? Yeah.

Well, I think that everybody should read Gail Carnegie's how to win friends and influence people because everybody's favorite topic is themselves. So,

You always lead with that. Whether you're trying to meet a mate, you know, you're trying to get a business relationship or you're just trying to have casual coffee. It's always best to ask questions and answer questions with specificity, which is what I'm trying to do here. But, you know, this is not that format. You're asking me questions. But if this is just a, you know, not on camera dialogue, it is just my nature to ask questions because I want to learn about like, why are we interfacing? You know, what is it that you're looking to achieve out of this relationship? And sometimes it ends up being different than what I thought.

So there's one topic that we kind of touched on off camera before we got going, which is the removing of certain periods of extreme outperformance from your results and managing investor expectations. Obviously, trade options, you traffic in volatility markets and 2020 was just an off the charts year for extreme outcomes there.

And you know, you sent me your, your track record before and you said, but we, we exclude March and April of 2020, because it's just not really relevant to what we expect moving forward. I mean, so many people killed to have a great period of performance and for the way that that kind of like juices the, you know,

you know, since inception return or the, the Kager or whatever it is that, um, is the flashy, you know, top line number that people are looking at. Um, so I, I love to hear how you came to that decision to sort of like remove outliers. And obviously you still have to give people your full track record if they ask for it. Um, but how do you manage that conversation, uh, with, with people who are, you know, really attracted to this thing that, you know, is super unlikely to happen again.

So we had just launched the fund right as COVID started. And so I'll give some more context. I was a biochemistry major. I worked in a lab that was right next to a gain and function lab. I've been trained formally in biochemical warfare by the military. So when it comes to things like COVID, I was uniquely suited to have an opinion about it. So our first real trades were buying coats in the S&P 500. Well, what we really did is we bought the first big trade we did, we bought

I think it was Broadcom. We bought volatility in Broadcom because Broadcom is out of sync with the rest of the earnings cycle. I think they had earnings in January of 2020.

And no, it was, we bought Broadcom on Apple. That's what it was. And we thought that the thesis was something like, well, Apple was going to come out. Tim Cook is going to be like, iPhones are amazing. You should go buy one. But, you know, there's this new sniffle going around and we think that, you know, the supply chain will be disrupted. So we thought that that would happen. And we were wrong.

you know, that happened in January and the volatility that we, you know, all these options that we bought that to zero, right. Close to zero. And so that sucked. So when it came to the first trades that we did, we were really short the market by being long puts a in smaller size than we would have. And it was dis representative of how we would run the book holistically. So the returns that we made on a percentage basis of capital were extremely high

and not representative of what we would be doing in the future. So we thought it was more honest to say, okay, potential investor, this is what we have and this is what you can expect. But if we have all these insane returns back in COVID, somebody's going to say, well, are you going to do that again in the next COVID? And I can't really tell them that we would because we didn't have on the parts of the book at that point that would have lost money. So our returns are just

not indicative of what investors should expect. Now, I would rather have like a really strong number in my back pocket and show them the rationale and the ethics that go into not putting that on our return stream, as opposed to saying like, we just crush it all the time, no matter what. And if the next COVID, we're going to make a thousand percent.

Not true. And I think that it is the correct thing to do as somebody who has like a long-term vision in his business to not only perform, but be completely transparent and honest about what has happened and what will happen to the best of your abilities. So if we get a COVID 2.0 tomorrow, do I think that we will make the same returns as we did in 2020? No.

That was the real thing. And it wasn't so much that we would underperform. It's that we didn't have on the losers and we did have on the winners. And the vol explosion was so swift. We don't think we could ever repeat that. Was that because of your understanding of the environment or just because you'd been so close to launch and just like the money just hadn't been put to work yet?

both. It was a unique nexus of things that it's just really never going to happen again. Again, I was very equipped to understand what, you know, gain of function research looks like and what is, what effects can be in human beings, how fast can it travel? And I was like, you know, if you took the, you know, 320 million Americans, I find the most worried guy, right? I'm like, well, this is going to be bananas. And then as I started to figure out what was going on with it, we knew about COVID in December. Um,

I became like the least worried guy, you know, kind of like walking around licking doorknobs and stuff like that. I'm going to get it. Okay. I, I, maybe, I may, maybe you've already had the Spanish lips from, you know, 1918. I don't even know. Right. But, um, you know, this thing is going to, you know, you change, it's going to morph, there's going to be different strains and, you know, we're all going to, you know, touch it at some point. And whether we die or not, it's just like, whatever. So, um,

My whole like investment thesis, you know, shifted, you know, pretty swiftly on that. And, um, again, we just had a bunch of puts on ASP 500. They paid off gigantically and we didn't have on other parts of the book that would have gotten hurt. So we decided from a compliance and a, a management of expectations that we should just not include that. So you talked about, obviously this is a long-term decision for you, for, for the vision for the fund. Um,

we haven't really gotten that as a holistic answer. So what is the long-term vision? What's the capacity constraint of these strategies? And if you could reach that tomorrow, what would it look like? Something around a billion dollars notional, which really is a few hundred million of actual invested capital. Then we start to see some alpha degradation. So if you gave me $2 billion right now, could I and would I take it? Yes. Would our returns suffer? Probably.

So, but by how, what percentage would it be? 50%? Would it be 5%? I don't know. It depends. Where are we starting at? What's our starting point? If you give me a billion dollars tomorrow, well, we're at the end of the year. You know, the VIX is pretty low. You know, the expectations for the future are, you know, pretty reasonable. So it's a harder thing. That's another thing. Like, you know, when we started, we bought a bunch of puts.

COVID happened, puts exploded, you know, and then we were able to ride that out. So again, that's just like, man, you know, that's never, that's not going to happen again. You know, so don't look people in the eye and tell them that's going to happen again, because it's just not. So we think we can scale for a while, but we, you know, if you gave me $50 billion, I put it in T-bills. Obviously, if you, you know, you have this consistent performance, like Kerry, Kerry can add up pretty fast. If you have a couple of good years on a big chunk of money, like why not go back to prop?

Um, because I want to build a successful hedge fund. I think I can do more with more as opposed to way more with less. And, um, I also have other business lines that I'd like to develop.

And that all kind of synergizes. So I, you know, there's other ideas that I have. And now that I've been around the block, I know that there's all these categories in which people in our business can make money. So my attitude is like, I can do that. I can do that. And, you know, those things all kind of interface and touch each other on some, um, some level. So my, my ambition is to have more of a holistic business that touches a lot of different aspects of what it is I do.

All right. Well, Noel, thank you so much for coming on the show. It was a pleasure. Sounds like there's going to be a lot of evolution for you and we'll probably have you back on. Thanks for having me.