I came across this video by Alix Pasquet on YouTube about how to think about the first year of starting a hedge fund. I’d highly recommend watching it, even if you’re not planning to start a hedge fund. The advice laid out is incredibly useful in how to think about creating structural advantages for any new project.

tl;dr

  • What has to be true to make your goals inevitable? Create the structures and conditions that will help do the work for you.
  • Insight - very few people actually put capital to work at the bottom of the market.
  • SORAC = Scarcity of Resources Amplifies Creativity
  • Design content that will help you reach barriers to scale.
  • Know the financial return of your time.
  • Being higher energy within the same unit of time can increase the efficiency of that hour
  • Map the steps taken in your process to monitor and track the investment decisions
  • Failure comes from an inability to imagine failure
  • Read 1 book a week
  • Hiring - Keep a Virtual Bench

Year One Protocol : Investment Success

  1. Importance of Year One
    1. Most important year
    2. Sets the initial conditions (AUM, performance, team, culture) that then compound
    3. Pre-launch actions improve the probability of success
  2. Competitive Business Landscape
    1. The market is competitive and always changing - need to constantly find new sources of advantages
    2. Partnerships are fragile as there are large key man risks
    3. Assets are prone to be poached, and the firm has limited enterprise value
    4. Failure odds are relatively high (restaurant level)
    5. Attracts smart, competitive, wealthy people
    6. Predatory business
    7. The goal is to stack odds pre-launch
  3. Inevitability Thinking
    1. Evan Pagan’s Inevitability thinking mindset. Goal: make the desired outcome inevitable by creating the conditions and structures
    2. Structures do the work fo you
    3. Example: Hiring a coach for workouts, not keeping unhealthy foods in the house
  4. Ideal Way to Hack Year One
    1. Launch in a bear market (cheap stocks)
    2. Have access to capital
    3. Capitalize on a rare event (typically once a decade)
  5. Hacking Year One (Practical Steps)
    1. Conduct a Failure Point Analysis
      1. List the 20 smartest investors / analysts / allocators and ask “How do I fail”
      2. Ask about specific categories of information (position sizing, hiring, risk, marketing) - build a rapid pattern recognition of failure signs
      3. Do the opposite of the advice
      4. Aggregate conversations into memos for patterns
      5. Find unique processes / ways of investing
      6. This kind of targeted networking allows you to double level up by strengthening your network
    2. Competitive Advantages - apply competitive strategy principles to life and business and success by identifying your sources of alpha. Sources of advantages (edge) can be:
      1. Analytical
      2. Informational
      3. Behavioral
    3. Study Philosophy - allows you to see the unsee, feel the unfelt, and hear the unheard. Allows for variant perception - a differentiated point of view. E.g. comparing western and eastern schools of thought.
    4. Study Behavioral Finance (pre-launch) - topics include:
      1. Behavioral finance vs individual behaviour
      2. Group behaviour
      3. Complexity, Cybernetics, Systems Thinking, Chaos Theory
      4. Institutional / Organizational Behaviour
    5. Learn how to Manage Stress. The job is stressful and learning how to manage it will be helpful. Some practical tips:
      1. Learn recovery, nutrition, and working out
      2. Avoid over-reliance on nicotine, caffeine
      3. Major mistake in the hedge fund business is that people crash and burn - learn how to manage your energy since high energy is required in the investment business.
      4. Exercise resets the emotional system - and it is imperative to achieving the synthesis of physical / mental / emotional connection. Aging is going to impact energy levels and exercise keeps you young. There is high turnover in the industry precisely because people are young.
    6. Frugality - learning how to operate without resources is a huge source of advantage. Creativity is driven by lack of resources - scarcity amplifies. Learn how to create frugal conditions in the business. Admire and learn from frugal CEOs. Have a 10K and Pencil process - best analysts only need 10K, pencil, and imagination. Being able to operate without resources is a condition for success
    7. Living Expenses Outside the Fund
      1. Have 1-2 years of runway covered / 3-5 if you’re married
      2. Need spousal support, which provides peace of mind
      3. Runway also provides time to recover / find a job if fund fails - creates a personal margin of safety
    8. Solve for Isolation
      1. Startup PMs (Portfolio Managers) are often isolated
      2. People typically have underutilized networks (most don’t stay in touch)
      3. Lack of resources + isolation makes it hard to solve problems
      4. You need a thought partner - organize group gatherings / dinners
      5. Always pitch your best stuff (even if - and especially if - others hate it)
    9. Apply Value and Competitive Strategy Principles to Business
      1. Value investors are good at applying this thinking to their investments but bad at applying it to their own business.
      2. Understand the fundamentals - like barriers to entry, bargaining leverage, competitor interactions etc.
      3. Understand why you will attract smart people and analysts - what will make hiring effective for you? (Citadel vs Millennium)
    10. Need a Network of PMs - Because PM thinking is separate from analyst thinking - similar to how managerial thinking is differentiated from individual task owners. Need others to discuss problems “at their level”. Also helps to learn what not to do.
    11. Leverage your network - learn how to use the people already in your network to your advantage
      1. Ask for help pre launch, ask them to invest, ask for references, ask them to share their best ideas, ask to attend management meetings with them.
      2. Ask friends to share resources - research / industry primers
      3. Intellectual Capital Leverage is a crucial form of leverage - compounds quickly if you figure out how to be surrounded by people smarter than yourself.
    12. Have three “cinch” (easy task) ideas - pre-launch.
      1. Launch only when confident in future ideas (18-36 months)
      2. Cinch = no brainer, 100% sure shot way to make money
      3. Difficult to judge for rookies
      4. Ensures probability of success
    13. Pick the right fund structure - that in and of itself can be a source of alpha.
      1. Fund structure is the ‘boat’ to navigate the market
      2. Fund structures also relate to personality
      3. Read about - and study - fund structures
      4. Forms of Leverage (maximum two) - gross exposure, concentration, beta - high in all three leads to painful drawdowns
    14. Using the Right Investment Tools and Processes
      1. Premortem (before investment)
      2. Postmortem (after investment)
      3. Pre-parade
      4. WRITE Investment Memos
      5. Tracking tools (avoid common ones like credit card data)
      6. Bull / Bear Debates
      7. Constantly pick up and learn new tools
    15. Marketing
      1. Need a core group of investment partners (seed partner is ideal)
      2. Need the right terms on seed partners
      3. Meet potential investors pre-launch (as many as possible)
      4. Take small checks (psychological benefits)
      5. Investors asking questions reveals holes in the strategy - allows you to iterate faster
      6. Need tough skin - since you will face rejection (10% success rate is good)
      7. Continuously meet with potential partners - need to develop a system of continuously meeting with people
    16. Content Strategy
      1. Step one is to have one
      2. Important because it accomplishes business goals (like leverage). Buffet claims to have doubled his net worth by writing / sharing
      3. Content expands moats (e.g. Drive to Survive)
      4. Helps breach barriers to scale
    17. Know Financial Return of Your Time (Return on Time)
      1. Allocate time effectively (e.g. 50 hours a week )
      2. Leverage time for better returns
      3. Investment
      4. There is a power law distribution of returns amongst PMS - the driving difference between the results is how time is used
      5. LEARN how to manage your time
      6. Bringing high energy within a unit of time can make it even more efficient / productive
    18. Crawl, Walk, Run - Portfolio Management Principle
      1. From Soros - start tight (crawl) - and then increase your position and leverage as returns start to grow (walk, run). Arbitrary number examples are 7% crawl, 15% walk, 21% run.
      2. If you start losing money in run mode - bring that back down to walk.
      3. Rookie mistake is to start with high gross exposure
      4. The advice is to take it easy - slow down initially
      5. Lower gross exposure when starting business / portfolio / team - increase as you get ‘sea legs’ - and other management tools
      6. Have a daily process to identify problems / opportunities early
    19. How to Hire
      1. The business is about hiring smart and capable people - and is unfortunately something that is not taught in business schools. However books / experts on hiring exist.
      2. Lots of leverage in cracking hiring properly
      3. Apply the Astral Teller Principle - make something 10x better rather than 10% better. Use differentiated assumptions, questions, and tools.
      4. Analyze the hiring steps (expensive, time consuming, competitive, reflexive) - hiring is expensive so it’s typically a good idea to move steps around in order to find a better process.
      5. Hire from differentiated sources - avoid traditional , find those with reps / judgement
    20. Learn Liquidity
      1. PE buy and hold mentality has infected hedge fund thinking - whereas true hedge fund operations benefit massively from liquidity - arguably because liquidity means that you are not ‘locked into’ a position - you are allowed to be wrong and evolve your strategy according to the outcomes generated by your decisions.
      2. Liquidity is ‘beautiful’ - get out if you’re wrong, buy more if you’re right. PM’s have access to liquidity rather than PE.
      3. Prefer voice trading over computers - it allows you to learn from other traders.
      4. Learn about the stocks (fundamentals that are driving the business) vs Stock (supply / demand - aka inventory) in the short term
      5. Learn to take advantage of liquidity
    21. Year one protocol is for every year
      1. The advice above is to be repeated annually - one must enjoy the business.
      2. Don’t be in it just for the money - hire people who love the business - and are obsessed with the business.
      3. You have to love even the bad days - it’s a bit of a masochist trait.
      4. Alix’s first fund failed but he loved every day of it - typically for people who cannot do anything else. Meet cool people. Putting up numbers is a turn on for these types of people - who are seeking constant improvement, introspection and collaboration. Money is a motivation - and success - excellence - matters because he wants the son / children to be prouder.

Additional Notes and Advice

  • Invest in the goals of others- (analysts, CEOs etc)
  • Learn from other fields
    • Take what works and apply it ruthlessly - it is okay to plagiarize.
    • Can learn a lot from the NFL about coaching / talent selection / financial / strategic valuation of talent
    • E.g. Peter Kaufman was famous for reading scientific magazines.
    • Can learn a lot from directors and movie producers (about their daily practices ) - e.g. Jerry Brookheimer’s list / location tracking - director preparation, script discipline etc
  • Managing Stress
    • Have an early morning workout - allows you to clear stress, release more energy, clear the mental cobwebs. Cardio is super important to get rid of negative chemicals in the body - raise the heart rate to 80% maximum for 10 - 20 minutes to rest the emotional system.
    • Avoid bringing a bad day home - don’t allow it to color the rest of the day. Take a nap if needed.
    • Get positive chemicals out when cocky - market gods are always watching. So don’t get high off your own supply when winning.
    • Treat the body as a physical, mental, and emotional system.
  • Spousal support
    • You need spousal support if you are going to be in this business. A wife (poorly chosen) can very well be a liability - plenty of individuals who have lost their money to divorce, or have had the stress of their marriage pull them apart in other directions.
    • Google has a death benefit policy that in case of the death of an engineer - the spouse receives ongoing support - which incentivizes staying. Creates a source of bargaining leverage.
  • AI Tools
    • AI tools are not analytical tools - they are portfolio management tools.
    • Dangerous for analysts to use for bodies of work - as they can often be wrong.
    • Management teams are already aware of this - deception and theatricality are increasing
    • Conduct analysis on the data information that is provided by AI
    • Develop an understanding of the strengths and weaknesses of AI tools
    • Understand that your competition is not just AI - but human + AI
    • Generational battle - those who use analog tools only vs analog + digital tools - the latter tend to outperform the former.
  • Analytical Superpowers that AI Takes Away
    • Insight generation without constraints
    • Recall (which is important for pattern recognition - and only comes through via doing / getting the reps in)
    • Visualizing under constraints ( reading a 10K will force the reader to visualize the business - and imaging a customer buying the product / engaging with a service)
  • Challenges Faced by those coming from a Pod Shop background
    • Pods have many resources (management access, data, as well as talent pull)
    • Hard to leave and replicate resources
    • Goldman: Guy vs the Seat
      • Used to distinguish whether the success of an individual within the firm is due primarily to the person themselves (‘the guy’) or to the advantages and resources with their position (‘the seat’).
      • Goldman tends to promote specific individuals to partners - who are capable of making both ‘the seat’ and ‘the guy’ more valuable.
      • The challenges people who leave the seat face is replicating the structures and the advantages that were previously available to them.
    • You need to adapt and play a different game. A key mistake of new starting pods is that they start out too big. Pod problems are things like netting risk, center book (taking bets against other pods)
    • Need a track record or allocator relationships in order to do well. A portable track record is not easy. The other alternative to cultivate relationships is to advise on SMAs for other hedge funds.
  • Deliberate Practice Portfolio Management
    • Create a shadow personal account if you’re still just an analyst - an excel spreadsheet etc - track decisions.
    • Run the shadow account with different exposures - factor neutral, Jones, Beta neutral.
    • Analyze the best and worst ideas monthly
    • Pareto optimize the portfolio - Murray Stall (if you own 20 positions, then 20% = 4 stocks will be responsible for 80% of the returns, 4 stocks will be responsible for 80% of the losses). Force rank positions weekly and monthly. Adapt based on market, sentiment, competitors, crowdedness.
    • Run separate accounts with small money (learn from wins / losses)
    • Pipeline Meeting - the concept is to print out their current portfolio (longs and shots) and the ideas that individuals are currently working on “your pipeline” - and then meet with an experienced PM to get valuable feedback.
      • Show portfolio or pipeline to a PM for criticism. This can be valuable feedback even if it is confidence wrecking. Learn from counterarguments.
      • The purpose is to get get feedback, and learn how a PM thinks by asking questions and potentially uncover flaws or strengths in ideas - it is a way to counteract the isolation problem that startup PMs often face.
    • Good PMing is 80% of the business, no good books / classes on it
  • AI’s Impact of Investment Strategies
    • AI has been used since the 90s - RenTech is a prime example
    • Study the quant meltdown of August 2007 - similar positions caused issues
    • Learn how to compete against the machines (Tyler Cowen’s ‘Average is Over’)
      • The world begins to look like freestyle chess - human + machine advantage
    • Investing is a sport that has non-stationarity (outside forces, new entrants)
    • Understand the quantitative tools - and apply the schools of thought that are taught to the elite - for example you can check out OCW to understand the schools of thought and investing people are coming from - even if you can’t necessarily identify the exact algorithm etc.
  • 10K and Pencil
    • Scarcity breeds creativity and creates the conditions for success. It’s usually not a good idea to depend too much on sell side information.
    • Create information asymmetry in the field (talk to customers, competitors, suppliers, regulators) - buy and try the product if you can. E.g. Before investing in the GTA manufacturer, he ordered a gaming console and played the game.
    • “The desk is a dangerous place from which to view the world”
    • Develop your own hierarchy of knowledge / understanding / wisdom - not just information.
    • What gets you from data to information is GOALS
    • What gets you from information to knowledge is PROCEDURAL
    • What gets you from knowledge to understanding is EXPERIENCE
    • What gets you from understanding to wisdom is TEACHING
    • Differences in understanding / wisdom explain bull / bear battles with the same information.
  • Triangle Offence - identifying the three sources of advantages
    • Analytical - very competitive and it can often be difficult to get an analytical edge in the market today.
    • Informational - can be difficult if not at the very least - definitely expensive. Acquiring new or unique datasets tends to be pretty hard.
    • Behavioral - this is typically the most important for year one.
  • Why is an Investing Still Worth it despite the pain -
    • Alix loves the business, even on the bad days. Cannot do anything else. It is one of the great ways that allow him to meet cool people - and he likes the idea of putting up numbers - can be competitive.
    • It’s a business that requires constant **improvement, introspection, and collaboration **
    • **Likes making money, and ultimately wants his family to be proud of him. **
  • Learning in an ever changing environment
    • Learning from other people is the **best way **
    • **Discuss with other people in your craft / arena about how they do things **
      • Tom Brady example - he went and met Manning (the head coach of a competitor team) about winning strategies, and Manning was shocked when Brady and the Patriots applied the same strategy against him during the gameplay.
    • Focus on those who are making or losing money in the short term - there might be learning aspects from both - those who are winning, what are they doing currently that could be applied to your business; those who are losing - what are they doing incorrectly that you should avoid? Learning what not to do is valuable.
    • Learning from your own mistakes can often teach you the wrong lessons - since failure is often overdetermined. In case you do decide to do a post-mortem of your failures, do it three months after.
    • Much better advice is to learn from your successes (and identify ways to replicate them)
    • A lot of alpha in learning from different fields - a good piece of advice in your career is to try and identify opportunities where you are paid to learn.
    • Reading can be a huge source of advantage - a $10 book can have a $1M worth of impact.
    • There is a lot of value in the inefficiency of the reading process - it has constraints, it is hard to take notes, and find valuable information that is ripe for discussion.
    • Book recommendation - Alchemy by Rory Sutherland
  • ** Post-Mortem Analysis - How to conduct one**
    • Build categories (strategic, analytical, judgement, allocation)
    • Look for the source of mistake (strategic foundation, analytical foundation, value principles)
    • Value principles check: concept of value, margin of safety, competitive strategy / moat, opportunity cost, Rule #1 / 2
    • Did you position size incorrectly?
    • Conduct position sizing based on a maximum loss strategy
    • Avoid concentrated positions (rookie mistake - people like to do this because ‘Buffet recommends running a concentrated portfolio’ - well you are not buffet).
    • Run diversified
    • Solve for concentration with an SPV for great ideas
    • Understand that it is often hard to know what truly went wrong - since the game is often about hidden information.
    • Do a post-mortem three months after loss (creates emotional distance, and forces clarity).
    • Share postmortem with others for feedback - they might be able to pick out things that you may have missed.
  • Advice for starting an Investment Bank / Cap Raise Efforts
    • Add a tremendous amount of value to one client, ensure success, and use the same guy to identify other clients.
    • Failure point of starting an investment bank is often that cost structures get out of what as one starts to succeed - they start to hire the ‘big guys’ with ‘big names’ - and that tends to throw the culture out of whack
    • People forget the hustler mentality - and as a result of this the culture suffers
  • **Future Facing Views - Geopolitical Fragmentation etc **
    • Inflation / Cost of Capital is going up
    • Inefficiencies are going up
    • Sectors haven’t gone through a boom / bust cycle - e.g. PE / Private Credit
    • There’s been a global regime restructuring
    • Pay attention to Mexico - nearshoring, potential public companies
    • Study rail lines (canadian pacific) and surrounding areas
    • Pay attention to other geographies (SA Asia, Brazil, Columbia)
    • Travel - travel when younger, experience different things - speak to locals, build relationships
    • Locals travelling to new york often provide information advantage