Physicist hedge fund guru posts lukewarm returns

(MoneyWatch) Having recently read James Weatherall's book "The Physics of Wall Street" I was interested in the article "Against the Current," about Andrew Tsai, a physicist turned hedge fund manager which appears in the April 2013 issue of Institutional Investor.

Tsai is the chief investment officer of the Chalkstream Capital Group, a fund of hedge funds that was founded in 2003. The article discusses how Tsai needs to be exceptional as his clients are almost entirely partners and executives at hedge funds and major banks as well as asset managers who have entrusted Tsai with their personal capital. These are obviously people with high expectations. The fund's strategy is to "traffic in areas where there is not a lot of capital chasing for returns." Tsai added: "We think traditional asset allocation is very dangerous. We are not in the business of filing buckets: we are in the business of finding opportunities."

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The article is filled with praise for Tsai from such luminaries as Michael Burry (who ran the Scion fund and became famous for his bet against sub-prime mortgage backed securities). Robert Stavis, an early investor in Chalkstream and a partner in the venture capital firm Bessemer Venture Partners, stated that he was impressed by "what they are trying to do, which is not be just an index of alternatives but to have a thoughtful view on any part of the investment cycle and to try and articulate that by finding themes and investing in those themes." Arjun Divecha, chairman of the board of GMO, expressed his confidence stating: "What I particularly like is their choice of interesting investment theses. It is really the quality of the thinking and the analysis." The article went on to note that Tsai and his 12-member team "have caught some of the most interesting and profitable trades of the past decade."

Knowing that Institutional Investor has the benefit of hindsight and that the media in general highlights success stories, I expected to see that the Chalkstream had racked up impressive results. So, how did the fund do? Over the decade 2003 through 2012, the fund returned 5.6 percent. The good news is that those were great results in the world of fund of hedge funds as Chalkstream outperformed the HFRX Global Index by 4 percent. Unfortunately, that is damning with faint praise. Those returns lagged the returns of every major stock asset class during that period. Consider Chalkstream's 5.6 percent return against what Tsai referred to as "dangerous asset allocation strategies."*

• An all-stock portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned 10.9 percent.
• A 60 percent stock/40 percent bond portfolio with those weights for the equity allocation would have returned 8.2 percent using one-year Treasuries, 9.4 percent using five-year Treasuries, and 11.0 percent using long-term Treasuries.

In addition, Chalkstream apparently wasn't able to protect investors during the downturn of 2008, which is one of the purported benefits of investing in hedge funds. While Chalkstream gained 26.2 percent in 2007, besting the 5.5 percent return of the S&P 500 Index, it lost 44 percent in 2008, trailing the S&P 500 by 7 percent. 

This tale illustrates that being smart isn't enough to generate market-beating returns. It also demonstrates just how difficult it is to identify in advance the very few people who will beat the market in the future. And it demonstrates how difficult it is to overcome the fees that firms like Chalkstream impose. In their case, in addition to the fees charged by the 15-20 hedge funds in which it invests, Chalkstream adds on its own 1 percent management fee and 10 percent performance fee for its hedge fund portfolio and a 15 percent performance fee for its illiquid portfolio. Certainly, Tsai's investors would have been far better off with those "dangerous asset allocation strategies."

* The all-stock portfolio consists of 10 percent allocations to each of the following indexes: S&P 500 Index, MSCI US Small Cap 1750 Index, MSCI US Prime Market Value Index, MSCI US Small Cap Value Index, Dow Jones US Select REIT Index, MSCI EAFE Index, MSCI EAFE Small Cap Index, MSCI EAFE Small Value Index, MSCI EAFE Value Index and MSCI Emerging Markets Index. The 60/40 portfolio uses the all-stock portfolio for the equity allocation and the stated bond indexes for the fixed income portion.