Episode Transcript
The Finance Ghost: Welcome to episode 285 of Magic Markets. We are now in August. We are coming out of winter in South Africa and a very, very dry July in Cape Town. Not sure what the weather's like elsewhere.
Moe, you are still in the sunshine, or whatever that looks like really, in Canada.
And that's more than we can say for a certain hedge fund that has gone into a dark winter. A lot of news flow and a lot of excitement, and we thought that we would use what's happened at Situational Awareness - the name becoming very funny now - to talk about how things can go wrong for hedge funds and what's actually happened there.
And that, of course, is Leopold Aschenbrenner. I'm probably getting his surname wrong, but that's who we're talking about this week, Moe. And it's going to be interesting.
Mohammed Nalla: Indeed Ghost, one of our most popular shows a while back on the free Magic Markets podcast was when we discussed Archegos, which blew up. And I remember people were calling it "arch egos", probably very appropriate there.
What is it with these hedge funds and the names just really effectively defining their fate? Because “arch egos” blew up, or Archegos, let's call it what it was. And Situational Awareness has really become a story of a lack of situational awareness.
So I'm going to stop laughing here because it's really quite a serious issue out there. Let's unpack what it is. And I think, for listeners...
The Finance Ghost: We can make one more joke, one more joke about the name though, Moe. I gotta just tell you, I saw a meme - because obviously I don't want to give it away, but people would have probably followed this already, but Ken Griffin basically has played a role here.
And there was this wonderful meme that I saw online with a picture of Ken Griffin. And then the caption said, "The last thing you see as you become aware of the situation." It's like Ken Griffin smiling down at you, because he's about to buy your portfolio at a fat discount. So I thought that was rather funny.
Let's dig into it. Maybe for those who have no idea what we're talking about, you're good at storytelling. You set the scene for us.
Mohammed Nalla: Yeah, the show is going to be full of puns because, Ken Griffin swooping in like a griffin. And you can see Situational Awareness as this rodent. And maybe not so little rodent. Let me not digress. Let's get into it, right?
Situational Awareness wasn't a small hedge fund. He was actually running around $45 billion worth of assets at its peak earlier this month. A lot of that initial capital came through from some of the founders of Stripe.
And Leopold, as you've mentioned, he goes down in the early days as this genius. Everyone saw him as someone who was quite visionary, solidly backing the AI theme that effectively came to define the market. I guess he's going to be defined by the blowing up of his hedge fund. But in the early days, really stacked up some pretty impressive returns, and that's how you grow your portfolio to $45 billion worth of assets.
Now, that unravelled very quickly, and the one word as to why it unravelled, I'm just going to put it out there: leverage.
If you look at that, effectively he turned from this mega fund into one that was forced to actually sell his leveraged stock positions to Ken Griffin at Citadel. And their fund holdings reportedly dropped to around $10 billion. So that is a massive fall from grace.
His fund's certainly not dead. But what it does mean is that a lot of their public portfolio has been taken over by Citadel. I think they still hold some private stakes. Anthropic, there was a very big stake of Anthropic in the fund, and I'm guessing that's probably still in there as well.
But the story here, like I say, it's one about leverage. It's not about the trade going wrong. Because the long AI story is one that, you know, maybe lost a bit of momentum. That's certainly what's cost Leopold effectively most of his portfolio. But the real story was one of he was over-leveraged, the portfolio running at around 400% leverage, or four times.
And so, in that context, when you actually have the correction that you've seen in some of the AI names that he was exposed to, at the same time he was also short some of the software names, which initially were selling off quite sharply but subsequently bounced quite sharply off their recent lows.
So more recently, he was really hurt on both sides of the trade. His short positions were actually rallying. His long positions were collapsing. They were down. I'll go into some of the positions that he held.
And that's where Ken Griffin came in. He's really a specialist at this, at spotting when other players in the market are in distress. And you could argue, the market pushed Leopold to his point of maximum pain at that point in time, forced to liquidate his positions to put up more collateral to his prime brokers, obviously leverage coming into play there.
And as he does that, that obviously would build into the losses that he's experiencing because he's got to sell out on the positions. That means his longs actually going to fall. Even his shorts are going to rise because you've got to buy back those positions, close those out, as the margin call starts stacking up. And that's really how this kind of unravelled.
The Finance Ghost: Yeah, and you said it there, Moe, leverage. You can't go bankrupt if you don't potentially owe someone else. That's basically how it works.
And this is what hedge funds do. They use leverage, to varying degrees, to try and juice up returns. And I think it's important to recognize that once you get out of your typical long-only equity funds, where they have some kind of mandate, some kind of benchmark, they can't necessarily go short on anything, or certainly not if they're long-only. They can't necessarily add leverage, so they can't take derivatives, for example.
You can still lose money, but it's unlikely to be super dramatic. And it's probably going to be roughly in line with what the market does, and hopefully not too far away from the benchmark and all that kind of thing.
But once you get into hedge fund land, then all bets are off. Technically, depending on the mandates of the fund, it can be very, very broad. They can do long-short. They can use lots of leverage if they want to, if they're allowed to.
And especially in places like the US, where it's a little bit of Get Rich or Die Tryin’, to quote 50 Cent and age myself accordingly, then you can easily find yourself in a scenario where this stuff can actually happen, particularly in markets that can swing so wildly.
Like you say, I think what happened here was just he was very long a lot of the frothiest memory stocks and that kind of thing, just this absolute belief of these stocks will go up forever, which they won't, and then short stuff like Adobe. So he shorted things that have dropped really hard already.
He's long stocks that have literally gone to the moon. At some point that gap closes against you. And if you're then sitting with lots of leverage at that point, that's when you can actually very easily throw away years and years of gains.
That's what's happened here, because things don't go up forever and they don't go down forever. That seems to be the lesson that Leopold, for all his incredible brains and his essay on AI that went viral and everything else, he seems to have missed that small reality about investing.
Mohammed Nalla: Yeah, let's contextualise that because I want to touch on two points. You mentioned the leverage, so I'm going to close that point off and then we can go into some of the names specifically.
But why does this fund blow up so quickly? And you said 50 Cent. I'm going to be very tongue-in-cheek here again and say it's more like 25 cents if he's $10 billion on $45 billion. But I'm going to pause there because otherwise you're going to throw something at me through the screen.
The Finance Ghost: Possibly.
Mohammed Nalla: When you're looking at leverage, what a lot of people don't understand, as you've indicated, is that if you're unlevered and your book falls, say, 20%, 25%, that's very painful, yes. But you can reassess. You can decide whether your thesis is still intact, and you have time.
What leverage does is it actually shortens your time horizon. And with 400% leverage, or four times leverage, effectively, if the market falls by around 20%, 25%, that wipes out all of your equity buffer.
And that's when your prime brokers start calling you, saying, "Hey, you know what? We need more collateral." And in order to create that collateral, you're then forced into selling some of your long positions or effectively buying back some of your short positions. That's how it tends to build on itself.
So that's the leverage point that I kind of want to just close off, is contextualising that a 20% drop is then magnified by the amount of leverage that you put in the portfolio.
Now, moving on to some of the names that he was actually involved in. As you've correctly indicated, I mean, solidly a momentum trade here. I mean, Nebius, Bloom Energy, those might not be familiar to people. But then you've got names like SanDisk. And if you just go and have a look at that SanDisk chart - SanDisk was a rocket ship. CoreWeave, Cerence AI. A lot of those stocks rallied very hard, and perhaps he actually just leaned into that momentum.
But subsequently, a lot of those shares actually were down around 50% to 78% from their recent peaks. Now, that's a lot of pain. And even if he had a liquidity buffer, that gets eaten up very quickly when you're carrying that leverage into those kinds of drawdowns.
He's also had positions in SK Hynix, for example. That's been very topical out of Korea, IPO in the US, CoreWeave, another name that was quite hard hit. And those were some of the names that were then offloaded to Citadel.
Where does Citadel actually come into the story here? What is Ken Griffin actually doing?
Let's first maybe rewind and say that Ken Griffin - this is solidly out of his playbook because he generally goes in, he finds people that are distressed when they have margin calls and they become forced sellers. He goes in there and he effectively buys up these stocks at a discount.
And it's really quite important to note who makes money in these situations because someone like Ken Griffin goes in there, he becomes a liquidity provider, and the market sees him as someone who's effectively coming in, absorbing some of that forced selling.
Once the dust settles, it's actually not to say that, hey, you know what, everything's done, these stocks are actually cheap and now, the forced seller's out of the market.
I think there's a little bit more than that. If you follow Michael Burry, for example, famous for The Big Short, he actually used the bounce that you saw later in the week, as the market said, "Hey, you know what? A lot of this forced selling is out of the way." He used that to actually extend some of his shorts.
So I don't think we're out of the woods just yet. And that leads me to my very last point that I want to land on. And that is to say that when you're actually investing, and if you look at Leopold's fund, he had a whole bunch of names in there, but effectively he was still exposed to the same factors.
Having many stocks in your portfolio doesn't necessarily mean diversification. You've got to look at the catalysts of what's driving that.
Effectively his entire ethos was centred around the AI theme, around the supply chain bottlenecks. We've actually done some work on this in Magic Markets Premium when we covered some of these memory names and just how some of these cyclical stocks actually perform.
And again, maybe Leopold's a genius. Maybe he's a lot smarter than you and I. I mean, I haven't been managing $45 billion anytime recently. Neither is he right now.
But on that point, you can actually get your overall thesis right. But if you get your liquidity calculations wrong, if your leverage is too high, the market's not going to give you the time to let that thesis actually play out.
And we've seen so many stories like this. I mentioned Archegos. But if you go back, you can look at LTCM. I think that's the first classic story of really smart people, sophisticated thesis, but just too much leverage.
The other one, maybe on the other side of the coin, was Melvin Capital more recently. That was the whole GameStop saga, and Citadel again coming through and featuring in that story.
So every cycle is going to have its genius that comes through. Leopold, maybe he was the genius on this AI thesis. And it's not to say the thesis is actually dead, but he just didn't manage the portfolio, and specifically the liquidity and the leverage part of the portfolio process, well enough. And that's what's led us to the position we're in today.
The Finance Ghost: Yeah. And maybe just to expand on that. When you're going long and short on something, because hedge funds, they can be hedging for very different things. Unfortunately, it's a name that gets used for a whole bunch of different strategies. And often what they're just trying to do is actually achieve different returns to what the broader market is doing.
But they don't always do that. If they're just going long the hot names, then all they're doing is really just leveraging up what the market is doing anyway. They're not hedging anything. They're actually sitting there with the same underlying exposure that the long-only fund would have, just way more risk. Yes, way more potential upside as well, but nothing is actually hedged.
A different example of a trade, maybe just to finish off from my side, would be where you're looking for things that dislocate.
So among the hyperscalers, for example, Alphabet has somewhat been the darling. Microsoft has not. And so you've had this dislocation of the two, even though they're both big tech, they're both exposed to AI.
Yes, they're doing it differently. Absolutely. Gemini, OpenAI, not the same thing. Alphabet's got some additional tech and they're more of the value chain and all this stuff. And obviously Microsoft's got enterprise software as the underpin. Alphabet is more ads. They're not the same business.
But if you go back and you have a look at how the share prices have moved together, there's been this big dislocation in recent times.
And what a hedge fund might want to do, for example, is say, well, chances are that gap could close rather than open up further. So long Microsoft, short Alphabet, and you just need to be correct on a relative basis.
It's okay if Alphabet keeps going up, as long as Microsoft then goes up more. Where you'll lose out in that trade, obviously, is if Alphabet keeps going up and Microsoft keeps going down.
But that's why you do a trade like that with a decent margin of safety. Microsoft has already taken so much pain. Alphabet has already gone so hard.
And Leopold was the other way around. He was short the thing that's broken and long the thing that everyone loves, which is just not smart investing.
He might be right long term about what the world will do 10 years from now, 15 years from now. Will anyone even know what Adobe was? Who knows? But you can't play the markets like that. You're just not playing the valuation game. And it can hurt you really badly.
And unfortunately, at that scale, it can hurt you in a way that becomes historically significant, let's face it.
Mohammed Nalla: Indeed, Ghost. That's really the story. Momentum turned against him and he was just way too concentrated in a number of names, ironically, but in the same theme.
To wrap this up effectively, I draw a couple of lessons from this. The first one is quite obvious. Obviously the leverage point. Leverage changes your time horizon, it changes your risk tolerance.
But beyond that, you've got to actually look at things like the fact that a good theme is not the same as a good portfolio. He was effectively exposed to a whole bunch of factors on the one side and just got both sides of the trade wrong, the long and the short. You've discussed that.
The other point I actually want to raise here is that your hedge is only useful, as you've indicated, if it works when there's an actual drawdown.
And in this instance, he had software names on the one side, he had hardware names on the other side, and there was that intermarket rotation that's come through. Because if you look at the S&P on a headline level, it's kind of been flat. That's not where the action's been.
But within the sectors, you've seen massive rotations. You've seen double-digit moves in some of these names. That's not normal market activity.
And that leads to my last point, which is the fact that, yes, we've seen a bounce in some of these names, but that's not the same as a fundamental bottom because the key question we just still have to answer, we've again discussed this in some of our deep dives on Magic Markets Premium (if you're not a subscriber, go and have a look at that, it's only R99 a month) - but the key question is: as these companies invest in the capex of this AI theme, where is the return on investment going to be realised? And I don't think we have an answer to that just yet.
Perhaps this is just a blip. Maybe the theme continues. But I think the market's starting to ask a lot harder, tougher questions around this AI theme.
And with a blow-up of a hedge fund of this significance coming through, rippling through the market, you can certainly expect some of those questions to start to get a lot louder.
Unfortunately, that's all we have time for this week. Let us know what you thought of the show. Hit us up on social media. It's @MagicMarketsPod, one word, @FinanceGhost and @MohammedNalla, all on X.
Also go and find us on YouTube if you listen to your podcasts on YouTube.
And until next week, same time, same place.
Thanks and cheers.
The Finance Ghost: Ciao.
