The Hedge Fund Hunger Games
The first idea that Tim Harrington, Brian Tomeo, and Spencer Deering had for a business was to gather up brand-new hedge funds and nurture them. They’d invite them to make use of their office in Miami Beach, where they could get advice, legal help, expensive software, and eventually an introduction to investors, with the three benefactors collecting a fee. The second idea, the one the trio went with, was the exact opposite. They would assemble the hedge funds and make them fight.
This was back in April. The three had been introduced by mutual friends and colleagues over the years: Harrington, a 37-year-old with prematurely white hair who’d gone straight into hedge funds out of college, met Tomeo, 40, a broken-nosed former Princeton lacrosse champion, at a party not long after the latter left JPMorgan Chase as a managing director in 2007. Deering, 37, had come late to finance after first working as a teacher and writer; he had promise as a model-handsome charmer of wealthy investors. Together they sensed there was money in the nascent Miami hedge fund scene. Much like investing in a young tech company, hooking up a new hedge fund with seed capital—including, perhaps, some of their own—can be lucrative. The problem was that Harrington and his partners couldn’t tell which of the new funds asking for their money were any good.
It wasn’t easy for the aspiring hedge fund managers they were talking to, either. Investors won’t give capital to managers who have no experience, but managers can’t get experience without capital. Most fledgling funds try to get past this paradox by offering back-tested results, modeling how their trading algorithms would have performed in years past. This is basically historical fiction, and it ignores a fundamental truth of investing: What happened yesterday doesn’t predict what the market will do tomorrow.
What matters is actual performance, which is how Tomeo and Harrington came up with the idea to run a tournament to fill their incubator, weeding out pretenders by making managers compete in real time with real money. The finisher who made the most while risking the least would win the right to manage seven figures of capital. They called their company Battle-Fin.
A trial tournament in July proved that the mechanics of the concept worked. It also demonstrated how difficult it was to win: Tomeo entered and finished fifth out of six. For the next tournament, which they considered their real debut, the three men secured $10 million in money to manage from the investment arm of a brokerage and financial technology company in New York. Winners would be chosen in three divisions. The “elite” category was for managers who were already running other people’s money. The winner here would run $5 million of the prize capital. The “professional” division was for entrants risking any amount of their own money. The winner would run $3 million. And the “launch” division was for contestants trading only on paper. There would be two winners in this division, each to be allocated $1 million.
Battle-Fin restricted the tournament to quants—managers who develop computer-run algorithms that set rules for trading. Quants aren’t new to Wall Street by any means, but if you’re looking for innovative ideas, then computational finance isn’t a bad place to start. And hedge funds badly need new blood. With notable exceptions, they’ve been clobbered by the plain-old stock market in the last four years. In 2012, the average hedge fund has returned 3 percent; the Standard & Poor’s 500-stock index has returned 15 percent. Investors, meanwhile, pay dearly for the privilege of underperforming—managers typically keep 20 percent of any profit, plus a 2 percent management fee.
“We want to find great people, help them build their business, and build a great business on our own,” Harrington says. “If that turns the hedge fund industry on its head, that’s not our worry.”
In August, Alon Bochman was sitting at the desk he rents at an office near Grand Central Terminal in New York, reading posts in a LinkedIn group for emerging managers, when he came across one from Harrington. “Our real-time, real-capital tournaments democratically and objectively identify tomorrow’s best and brightest computational financiers—wherever they might be,” it read. A few clicks and an e-mail exchange later, Bochman was in the tournament.
Two and a half years ago, Bochman was earning a comfortable six figures as a portfolio manager at SC Fundamental, a New York hedge fund notable for launching the careers of a handful of wildly successful managers, including David Einhorn. One day he noticed an anomaly in the way a certain kind of exchange-traded fund behaved, so he devised a trading strategy for his personal account that wouldn’t require a lot of monitoring. “I never really looked at it. I had a full-time job I liked very much,” he says. “Then, around December, I got a statement from my broker. And I was like, Huh.” Bochman’s returns had passed 30 percent a year. In March he quit to start his own fund.
Even with his connections, Bochman, 39, found it tough to get a piece of the money streaming into billion-dollar funds. He knew that, as in any industry, pitching hedge fund investors meant hearing “no” a lot. What he wasn’t prepared for were the questionnaires from due diligence firms, the industry’s post-Madoff gatekeepers, which struck him as both invasive and superficial. Asking about strategy and risk tolerance made sense. But his heart condition? Whether he was in the midst of a divorce?
Of every dollar flowing into the industry, 96¢ go to the biggest hedge funds, those with more than $5 billion under management. For upstarts, getting capitalized usually means hitting up friends and family, then approaching professional contacts, and gradually moving upward. Performance is the most important factor for attracting money, but allocations are often won or lost on the margins of personality—knowing the right people, having impressive literature, nailing the interview. “The hedge fund industry is supposed to be merit-based, and it’s supposed to be entrepreneurial,” says Bochman. “I think that people have been so shell-shocked by the financial crisis and Bernie Madoff that they’ve given up on merit. They’ll settle on a checklist that ensures you belong to certain clubs, know the right people.” He found the tournament concept refreshing. “What they’re doing is important. They’re one of the few guys saying, ‘This is a contest of ideas, and may the best strategy win.’ This is something that our industry really, really needs.”
Bochman was one of about 3,000 visitors to Battle-Fin’s website after Harrington and Deering began promoting it, which in the small world of aspiring quant hedge fund managers is a lot. About 130 applied.
“The pedigree of the guys who are coming across our screen—it’s crazy,” says Deering. (One of the two finalists in the trial tournament was a group of Massachusetts Institute of Technology Ph.D.’s.) “The fact that these guys are coming to us, in these little tournaments that we’re running? It’s so evident that the system is cocked up.”
The funds chosen—26 in all—were run by a motley bunch. Two master-level chess players headed one, which they called Chessica, after the original name, Genius Hedge Fund, failed to go over well with investors. Another fund, ProForza Advisors, boasted a rocket scientist who had worked for NASA, studying weather in the magnetosphere. Yet another contender, Stephen Longo, a Fu Manchu–mustache-sporting Long Islander, had spent 20 years as an engineer at General Motors. He had been racking up impressive gains on a theoretical trading platform for years, making millions, but only on paper; winning the tournament would give him a chance to prove his investing chops without a safety net. Martin Rosenburgh, who managed $1 million of friends-and-family money from home on a 27-inch iMac, was also optimistic. Should he win, he hoped to focus on his fund full time. “It’s like American Idol for quant strategies,” he says.
Several contestants spoke of the difficulty of getting in the room with potential investors. “We’re extremely good at the statistical analysis and data visualization and so forth,” says Mark Maldonis, 48. “But marketing skills? God was not good to me.”
Trading began on Oct. 1. From their offices in New York, Los Angeles, London, and elsewhere, the contestants tracked each other’s gains on a leader board updated daily at battle-fin.com. The launch category, where the gains or losses were all on paper, was naturally the most volatile. Longo was up 10 percent after just seven days, with a strategy that took its cues from volatility in the S&P 500. In the $5 million elite category—where the contestants were managing real money belonging to real clients—the range was much tighter, within a point or two of zero. Two weeks in, with the stock market down, even flat returns could be regarded as an accomplishment.
Perhaps the most impressive performance was in the intermediate division, where the managers’ own money was at stake. Rosenburgh, 45, had gained nearly 4 percent by the end of October, but he was quickly left in the dust by the 10 percent returns of a fund manager listed on the tournament scoreboard as Z. Liu. Nobody could dig up much information on him, but with a strategy built on the statistical analysis of historical trading data, he seemed proof that the Battle-Fin tournament might be able to pick managers better than Wall Street.
Dealing with startups often means forgiving a certain amount of amateur behavior. As the contestants entered the second month, several realized something: Battle-Fin was just as much a startup as they were.
Harrington handled the tournament’s day-to-day operations—checking in with contestants, putting out fires, and generally behaving like a theater manager on opening night. Tomeo was the high-level strategist. Deering was in charge of marketing. They had put the tournament concept into practice as rapidly as they could after inventing it. This meant hiccups, corner-cutting, and a lot of improvisation.
John LaChance, a former vice president at JPMorgan, logged on to battle-fin.com one day to discover an organization called “LaChance Capital” next to his name. “There’s no such thing,” he says with a laugh. “I guess they just put that down. I don’t think I’d name it that, either.” Several competitors noticed that five funds disappeared from the leader board without explanation. The head of ProForza Advisors, Sunil Pai, hadn’t even signed up to enter the tournament. One day over the summer, he says, he had called Harrington to learn more about the contest after seeing a LinkedIn post. The next thing he knew, ProForza was listed in the elite category. Harrington “entered us into the competition. I hadn’t actually applied for it,” says Pai, 49.
Midway through the tournament, even some high-level decisions had been left up in the air. “It’s definitely a work in progress,” Harrington says. Who was Battle-Fin’s chief executive officer, anyway? “I don’t know,” Tomeo says. “Who do you think it is?”
All three founders were concerned that two months was too short for a tournament and that they’d end up crowning the merely lucky. The partners also hadn’t figured out how to split revenue on the fees they’d collect from connecting the tournament winners to the capital providers. “One, we trust each other, and two, we’re not fighting over future spoils that haven’t even appeared yet,” Harrington says. “I’ve seen so many businesses where people are fighting and clawing for percentages that never even end up working out.”
There are no signs of tension among the three—the reverse, actually, thanks mostly to Deering’s nonstop comedy routine. A college lacrosse player like Tomeo, Deering taught English at a Chicago-area high school after graduating and self-published a novel about a man, a motorcycle, and the West. Today, he may be the only man in hedge funds who’s written about Southern food for Esquire and relationships, under a pen name, for Cosmopolitan. (“If you’re feeling the love itch, chances are he is as well but is too chicken to be the initiator.”) A theater director in Charleston, S.C., where he lives, nicknamed him Johnny Touchdown.
Harrington had traced a semi-charmed path through the hedge fund world. He started with an internship in college; skipping the usual period of apprenticeship at an investment bank, Harrington then bounced from one billion-dollar operation to the next—Galleon Group, SAC Capital Advisors, JPMorgan. (At the moment, two of those firms are known for scandal: Galleon’s founder, Raj Rajaratnam, was convicted in 2011 of securities fraud, and SAC, headed by Steven Cohen, is the subject of a federal investigation into insider trading. Harrington declined to discuss the topic.) He left JPMorgan in 2009 to start his own business, a hedge fund seeder called Lion’s Path Capital, which is tied to Battle-Fin in several ways. It staked the $1 million prize for the company’s trial tournament, and winners use Lion’s Path’s trading platform to manage the capital they win access to.
In Miami Beach, where the finance scene is tiny, Battle-Fin rents office space from Ray Langston, a hedge fund manager who’s a generation older and represents the success the trio hope to have and the old guard they mean to destroy. Langston collects Ferraris, drives away from lunch in a $440,000 Porsche Carrera GT roadster, and doesn’t care what you make of his calling President Obama a socialist. Hedgies of Langston’s era had the good fortune to trade amid a decades-long bull market. Back in Battle-Fin’s conference room, Tomeo says the managers in his tournament, with their computational skills, would eat Langston alive. “I just say, Hey, Ray, I would love to see you make it today,” says Tomeo. “I’d love to put you against these guys that I find.”
The contestants were putting up strong numbers. In the tournament’s final days, 8 out of 10 funds in the real-money divisions were beating the S&P.
LaChance, 37, lives in Pittstown, N.J.—horse country—in a 5,100-square-foot house with a three-car garage on two acres that he bought in 2006, at the absolute top of the market. It’s beautiful, an hour and 40 minutes from New York, and the school bus picks up his twin 12-year-old boys right at the curb. The Tuesday after Thanksgiving, a wet snow is falling, and LaChance misses nothing about his old commute, back when he was a JPMorgan trader. Wearing a North Face fleece and socks, he walks into his ground-floor home office, equipped with three widescreen monitors tracking $2.5 million of friends-and-family money in his portfolio. He is up 4 percent in the tournament’s top category—too high for anyone to catch up. For him, winning will be anticlimactic. Harrington has already had him record a victory video.
LaChance runs a handful of strategies at any given time. He mostly trades ADRs—American depositary receipts, or securities of foreign companies that trade on U.S. markets—that he believes are mispriced. LaChance says it’s profitable but not very scalable. “On some of these things, I’m literally the only person trading it,” he says.
In the 12 months leading up to the tournament, LaChance’s return was 39.9 percent. If he repeats that performance in 2013, with $5 million in Battle-Fin money in his portfolio, he stands to make an extra $399,000 in fee income. If his strategy goes bust, he’ll make nothing: Hedge funds ordinarily charge a 2 percent fee on their assets under management, which guarantees them revenue even in a down year, but Battle-Fin’s rules restrict winners from doing this.
For Longo, 54, winning is more surreal. The former General Motors engineer held on to his early lead in the launch category, giving the paper trader $1 million in real capital to invest. “I’m slightly speechless,” he says. “It’s kind of a double-edged sword. I’m obviously happy that I won. The other side is that now the real competition starts, with the markets.” Longo is truly speechless when a reporter points out something Battle-Fin had never told him: They’d be keeping the first 5 percent of any gains he made on the $1 million, in exchange for taking a risk on a total unknown. The asterisk applies only to his category. After recovering, Longo says there’s no hard feelings. “There might be a few misunderstandings or a few things that are unclear at this point, but again, the opportunity still far outweighs any of that,” he says.
Rosenburgh fared better under Battle-Fin’s make-it-up-as-we-go-along approach. He never climbed out of second place in the intermediate division but was thrilled to discover that he’d won something anyway. Battle-Fin had decided not to name two winners in the launch division after all, in favor of a floating $1 million “wild card.” In late November, Rosenburgh joined the other winners at the Lion’s Path offices in Manhattan, grinning in a group photo with Harrington.
Afterward, the victors walked to a nearby bar. Among them: the mysterious Z. (Zongjian) Liu. He had posted an astonishing 14 percent return in just two months in the intermediate division, risking his own money. As Liu began to explain his strategy and his background, it quickly became clear that he had not thought through the implications of winning $3 million to manage—or even competing in the tournament in the first place.
Liu, 34, has a full-time job at a major bank. Every bank’s rules are different about what employees are allowed to do with their investments, but publicly traded, highly regulated banks generally want to know if their employees are running hedge funds in their spare time. Liu hadn’t cleared his participation in the tournament with the compliance department. “Ideally, I should not do this,” he says in nearly perfect English. “Because there will be conflict of interest. Although in my case, there is no conflict of interest.” In two months, Liu says, he will probably quit to manage his portfolio full time. His plan is simply to not let the bank’s compliance officers find out.
Before the tournament, Liu says, he ran about $390,000 in friends-and-family money. If he keeps up his annualized 2012 rate of 43.6 percent next year, performance fees on $3 million in Battle-Fin money would run to $295,608. That may be more than his bank salary, but Liu would also be taking on a huge personal risk. If his models stop working as well and he merely matches the industry’s average 2012 return of 2.9 percent, performance fees on that $3 million would total only $17,400. Before expenses and taxes.
On the last day of the tournament, Nov. 30, Harrington is unsure how the man he has entrusted with $3 million is handling the situation. “We say to people, ‘Look, you have to get clearance from your employer to see if there’s any conflict of interest.’ His whole thing is he said he plans to quit. So, I mean, it’s a little—that’s the one that I don’t know how …” Harrington doesn’t finish the thought.
There are grander plans to discuss. Harrington has just come from a meeting with an investor who’s considering fronting as much as $50 million for a third tournament. At the same time, the trio want to take the concept beyond quant trading strategies to commodities, currencies, real estate. “The whole asset management industry is ripe for a technology that turns it upside down,” says Tomeo. Of course, they also want to go global. “We’re going to do Battle-Fin Latin America,” Harrington says. “We’re going to do Battle-Fin Canada. We’re going to do Battle-Fin Asia and Battle-Fin Global, which is when we’re going to take all of the winners and bring them to Miami for kind of a conference and showcase them to different people.”
A few days later, Harrington e-mails to say he’s hopeful the company will win a patent on the tournament. “Things are really moving fast,” he writes. Below his signature is a new Battle-Fin slogan: Time to sink or swim.