When reading Aristides Capital September 4 letter to investors, sent to sometimes ignored email boxes over the Labor Day news dump weekend, the mindset of a hedge fund during a dark period comes to life. Christopher Brown, Aristides Capital managing member, uses the letter to remind investors that all funds have periods of negative returns. It’s not how the fund manager performs during positive market environments that matters most, but how they manage during negative times that matters – although in this case the hedge fund had a really good August.  One theory on hedge fund investment management is to place more significant evaluation weighting on how a fund manager reacts during negative market environments. For Aristides, their recent negative period hasn’t been all that that bad, the fund points out in a recent letter.

Aristides Capital August
Aristides Capital

Aristides Capital had a visitor in May who judged the fund based on worst performance analysis

In May of 2016, when Aristides Fund LP was finishing up its fourth negative month of 2016, with an 80% monthly losing percentage year to date, things might have been looking their worst. For a fund boasting an average annual return of 17.95%, the negative period of time can be challenging but for all hedge funds and even passively managed index products they eventually come.

One method to evaluate a hedge fund is based on their risk management protocols. In fact, some algorithmic evaluators consider downside volatility management as the key component to model how a strategy might perform during various market environments.

It was in the middle of May, when Aristides was clearly in their self-acknowledged worse period, that they had a revelation, which is described in the investment letter:

In the middle of May, we were down roughly 6% year-to-date, and the metal front door to our office literally fell off the outside of our brick building as I was leaving to go home on Friday evening. Our largest investor visited us the following week and the fellow who runs the firm, who has been at the investment business in one form or another for decades, cheerfully said something like “So you’re only down 6% for the year? Your biggest two positions have been a disaster and nothing much has worked this year, and your only down 6%, not 20%? That doesn’t sound too bad.”

In algorithmic risk management, sometimes the best method to evaluate a firm is when they are at their worst. With CTAs, for instance, the beta market environment is a major factor in certain strategies. The notion is that managers who can weather the negative without significant losses can let beta take care of itself to the upside. Said another way: control downside deviation, treat upside volatility differently. This is not the mantra of all, but some fund managers have been known to manage downside risk differently than upside (positive) price volatility.

Focusing on how a hedge fund performs during negative market environments is a key method of analysis for a noncorrelated strategy, which Brown manages. From his standpoint Aristides is operating a machine of sorts. When the machine operates during inevitable periods of negativity these are the moments the system should be most closely evaluated. Negative returns should be expected with all noncorrelated investments. The key during negative market environments is keeping risk management generally tight and using a consistent process, one ideally explained to investors along with risk modeling during various market environments.

“Even if our results are from a good investment process and not just really amazing luck, there are still going to be some months, and some years, that are better than others, and some months that are worse than others,” he wrote. “Every system with signal still has some degree of noise. There are times when the market will be more or less amenable to the sort of things we try to do.”

The Aristides Capital system sputtered most of the year, then August came.

Aristides Capital Up 8% in August

In a month the fund was up 8%, erasing its previous year to date loses, Brown was circumspect. Don’t get overly excited about the winners is always tempering the highs with the lows. There are inevitable periods when a system won’t work much like when it does work, and then there are certain situations where being smart and being lucky can merge.

Citing luck in certain stock picks – SAExploration being one operative example – Brown discusses how to mark value of lightly traded shares in early stage investments. After trading at over $1,300 three years ago, Aristides hopes to ride this buy on a drawdown stock back to health. The stock, now trading at $10.45, was required to be valued by the fund during August because they invested in a restricted securities, according to Brown. The restricted security is not freely traded on an exchange and the stock is discounted to shares which are freely tradeable on an exchange, he explained. The exact level of the discount used to calculate the fund’s August results remains unknown, but the stock had a significant impact on returns.

Not all trades were winners. A trade that went against the fund was Energous (WATT). The company had shorted the stock, which has been in a strong uptrend since mid-January. In the fund letter, Brown alleged that the company’s technology could “cook human flesh” and that it would not receive regulatory approval:

…The company’s first commercialized product will be a failure (basically it will be able to, with incredibly slowness, charge your phone wirelessly from a distance of three feet or less, provided your phone is at exactly the right angle). The company’s second commercial product will interfere with WiFi and cook human flesh, and won’t ever get FCC approval. Importantly, in addition to many competent people saying these things, I have heard with my own ears that the CEO is a ridiculous snake oil salesman, who seems to be following the exact script of Unipixel and ImageWare in his communication with investors and analysts.

When asked to cite studies to back up his claims, Brown made the following statement to ValueWalk:

Energous’ miracle technology is simply microwave radiation. The FCC-approved product, which is useless, will not cook flesh. We believe that math shows pretty plainly that in order to charge a phone meaningfully at the kind of distances they are talking about for their next-generation product (which notably does NOT have FCC approval), that the level of microwaves needed would both interfere with other devices, in addition to being above the safe threshold for human exposure, including the potential for damage to flesh from repeated, significant microwave exposure.

Aristides Capital shorted Tesla after WSJ article

Speaking of technology that is used to incinerate, Brown shorted Tesla Motors shares and said in a statement to ValueWalk the short occured just after the Wall Street Journal ran a critical article on the firm.

Elon Musk’s proposed acquisition of Solar City seems to have greatly damaged his credibility among investors,” Brown wrote, as general speculation has centered on Tesla being given a much shorter leash in terms of price earnings ratio. This is an important development because it is Musk’s “perpetual access to low-cost capital was a key pillar to make the Tesla story work.”

Brown has more to share on his Musk / Tesla thesis that may be revealed at a later date. Just suffice it to say Tesla is at “the key turning point as to why all of the obvious flaws will finally matter for the stock.”

In other words, could the bubble of a tech unicorn be on the verge of popping?