At the height of the 2008 financial crisis, investors would have had a gain of more than 600 percent. Sound amazing, right? Well those numbers are just backtested, but still sound really good right? Well… maybe something that sounds too good to be true…..

By the standards of most hedge fund investors, losing 5% in a month is pretty much of a disaster, and certainly reason to review your position in the fund. Every now and then you will even hear about a hedge fund that managed to lose 10% in a month, usually in the context of investors are fleeing the fund or the manager resigned as no one wants to be associated with those kind of losses.

 

Once in a great while, you will come across a case where a hedge fund manager is stuck playing out a leveraged losing strategy and ends up losing half or more of the investors’ funds. Such was the case with the Spruce Alpha hedge fund in August, as the highly leveraged fund lost 48% of its value in that one month alone. It seems the “hedge fund” was not so hedged after all.

 

Spruce Alpha

The cautionary tale of Spruce Alpha

Spruce Alpha, a small hedge fund launched in April 2014) was supposedly designed to profit from volatility, but it clearly failed to turn the turmoil in financial markets in August to its advantage. In fact, Spruce Alpha had a disastrous month, suffering 48% losses, based on documents seen by The New York Times.’

In regards to back-testing the NYT notes:

To sell the fledgling fund to investors, Spruce emphasized not only an outsize hypothetical performance going back as far as 2006 — but also that one of its top managers, Robert Stock, was a former researcher who had worked on simulations of laser defense missiles.

And

In a disclaimer to its marketing materials, Spruce Alpha also noted some of the unreliability of back-tested returns. The hypothetical results “do not represent the results of actual trading” and “were achieved by means of the retroactive application of a hypothetical model that was designed with the benefit of hindsight and could be adjusted at will until desired or better performance results were achieved,” the disclaimer reads.

The tests had apparently not simulated a situation like Aug. 24, when some E.T.F.s seized up in the first few minutes at the start of trading. But a handful of nimble managers still managed to excel, some even maintaining double-digit returns for the year at the end of the month.

The less-than $100 million fund (managed by Spruce Investment Advisors), which was involved in complex, leveraged ETF trades that went sour, has moved all its positions into cash for the time being, according to a knowledgeable source. Of note, investors in Spruce Alpha have been told they can redeem the remainder of their money if these want to.

Analysts point out that the catastrophe at Spruce Alpha damages the reputation of Spruce Investment, the well-known firm led by John C. Bailey, who formerly worked at an asset management firm associated with Pimco.

Spruce Investment is a money manager for the wealthy and institutional investors. Around half of the assets Spruce Investment manages belong to three family offices, a separate corporation and a pension plan.

The Spruce Alpha fund was the firm’s first effort at self-directed hedge fund trading. Until the recent meltdown, Spruce had announced plans to raise up to $500 million.

In its marketing materials for the fund, Spruce Alpha focused on hypothetical performance going back to 2006, and also that one of its managers, Robert Stock, was a researcher with an engineering background.

Stock, however, resigned from his position at the firm in April. Hedge fund analysts highlight that a number of other top execs have also left Spruce Investment in the last few months.