Welcome to another episode of Goldman Sachs, Exchanges, Great Investors.
I'm Tony Pasquarello, Global Head of Hedge Fund Coverage and Global Banking and Markets and Co -Head of OneGS.
And today, I have the great pleasure of sitting down with my friend, Paul Britton.
Paul is the founder and CEO of Capstone Investment Advisors, a global investment firm with about $11 billion in assets under management.
Capstone focuses on derivatives and strategies that capture alpha and protect against downside risk.
Capstone recently celebrated its 20th anniversary.
And so this will be a great opportunity to discuss how the investing landscape has changed in the past two decades and where opportunities could be now.
Paul, thanks for doing this.
Thanks for being here.
You're welcome. Glad to be here.
Thank you for the invite.
So I want to get your take on the current environment, but let me just go back to the beginning.
Let's just start the beginning of Capstone.
What were the origins?
What was the impetus, why did you decide to launch the business in 2004?
My DNA is in the options market making space.
And we built a relatively successful firm.
And then I moved over to the States in 2000, 2001 to look to expand our European operations into the US.
By kind of 2003, 2004, I realized that the market making business and the providing liquidity business was really becoming a technology arms race.
So the more capex you would spend, the higher probability that you had of being the most successful in the game.
So it felt to me like it was a winner -takes -all game.
And who knows? Today, I could be sat here of having capstone securities and competing alongside Goldman Sachs securities or Citadel securities.
I think it's a relatively low probability outcome.
So I said, you know what?
I think that there's an opportunity to, it always frustrated me of not knowing what was going on on the other side of the world and what was going on in other asset classes.
So I said, you know what?
I'd like to build a global business.
I'd like to build a business that encompassed every asset class.
And I think this is useful for institutional investors.
And I certainly didn't have that fully formed in terms of what the end game looked like.
But that really was how I thought about it at the beginning to build a big global business that covered every asset class.
Right. And who knows?
But I think we'd probably agree the instinct was probably correct that the path you struck was the right one.
Listen, I can't complain.
I sat here with you.
11 billion of A &M later.
And I remember distinctly people being like, gosh, mate, if you ever get to a billion dollars, and that sounded incredibly scary to me.
And then you trust the process, you trust the people around you, and you're sharing your story and your vision with investors to be able to see whether investors buy into that narrative and that story as well.
And along that path, when was the first moment where you thought, okay, I think I'm onto something big?
So I remember distinctly January of 2008.
This story ends badly, by the way.
But it was one of those first aha moments where I'm like, wow, this could actually really work.
And it was MLK Day in January of 2008.
and one of the large European banks disclosed that they had a potential issue and there was an awful lot of volatility on that holiday day in the US and we made a decent amount of money.
And that was one of the moments where I'm like, oh, I get this.
You have sizable capital where you can put reasonable amounts of risk on and you're going to get rewarded for that.
and that was my first kind of aha moment of saying, all right, this has to be a scalable business and I see how this can really work.
And if you push forward to say the year 2020, was that another signpost when you said what we have built in scale is here to last?
Because that was a spectacular year for what you do.
Yes. The January 2008 story was great.
We made a lot of money for investors.
We did spectacularly well.
But it gave us, looking back at it, a real false confidence.
And then it went spectacularly wrong in Q4 2008, where we realized that, or I realized that, we didn't have the appropriate rigor framework around risk that we needed to.
And then fast forward to 2020, where you had an extraordinary event.
it was now. There's lots of sleepless nights, but you could feel that the framework was there and the level of comfort that gives you as an investor, as a business owner, knowing that all the processes are in place, people know exactly what to do.
That was a very gratifying year.
And not because we made money for investors or it's just that things worked as they should have done.
That really comes from the experience, the lessons, the mistakes, the stupidity of things we've done in the past.
Then 2020 was really a test to see whether we've learned or not.
Was there any other moment or period of time, again, along those 20 years that were particularly difficult for you or for the business outside of the fever pitch of crisis like 08 or 2020.
I think that the most difficult from an investment standpoint was definitely Q4 of 2008.
I'm not particularly religious, but I remember going to the bottom of Broadway at the intersection of Wall Street.
There's a beautiful church called Trinity Church right by here.
And I remember distinctly going there on a regular basis, not because I was seeking solace from a higher power.
But I found it so overwhelming of what was going on, and I needed a place of solace and a place to try and collect my thoughts and definitely ask for help from a higher power to be able to try and help me get out of this mess I'm in.
And so I'd end up having these wonderful conversations with these, these terrific vicars and priests at Trinity.
And then I'd come in on a relatively frequent basis and they would be like, how are the volatility markets today?
And so that was a moment in time of extreme stress, but acknowledging that you're literally putting one foot forward and learning from the process.
So from an investment standpoint, But that ultimately defined the firm.
Sure. Big pivot off that.
Let's talk about the derivatives market.
Yes. It is a hallmark of what you do, how you take risks, how you manage risk.
You're an options guy.
I came up in the business as an options guy.
The derivatives market has expanded hugely in the past decade or two, particularly, I'd say, in the kind of COVID, post -COVID era.
Yeah. Has that opened up the opportunity set for what you want to do, or has it made it more crowded, more difficult.
How has that all played to your strengths or to your detriment?
So when we started this back in 2004 and we took in institutional money in 2007, that discussion around what size, what capacity could you really be, I always was very, I was surprised by investors would always push back on us becoming bigger than 500 million or, because when I looked at the size of the derivatives
market, it was just enormous.
even back in those days and so 20 years ago I think the derivatives market was really used by the professional community and less in and there was certainly big pockets of retail participation but what I think has happened over these past 20 years is the evolution of the derivatives market to make them
more mainstream and to make them more appealing to a broader audience.
And there's lots of people that I think have done a very good job around the exchanges, the dealers, the banks, et cetera, to be able to figure out ways of enhancing the derivative offering to a wider group of participants.
For us, that's good, meaning that as long as there is more volume going through those pipes, then that should translate into a higher alpha proposition.
Just simply if there's more volume going through those pipes and there's more volume going through our filters, then that should translate into a higher alpha proposition for our investors.
It sounds like one part of that is liquidity begets liquidity.
In other words, if the market's getting bigger because of more market participants, you can take more risk and scale your risk.
But also, it's going to create alpha opportunities because not all of that money, not all of that capital flow will be as elite, perhaps, as you all.
Yeah. And it's not even elite.
It's that the great thing about the derivatives markets is people use them for different reasons.
If everyone just focused on the volatility component of the derivatives markets, that would be a challenge for us.
They don't. They focus on using derivatives for a whole variety of different reasons.
And even when you speak to some participants of the derivative markets who are sizable participants in them and sizable users of derivatives, they don't really care about the same alpha factors that I do.
That's not to say that we're elite.
It just means that we're after something different to the average participant and the average user of the derivatives markets.
And that's what I think makes what we do relatively unique and a relatively unique source of alpha for investors.
Got it. And then you are a US -based firm, you're a downtown -based firm, which I think actually owes some of its heritage to 9 -11 and your commitment to stay downtown, plus 9 -11.
But you're running very much global business.
Yes. So how much of your time is spent in non -dollar markets?
Obviously the US market is enormous, top to bottom.
But are you also taking a fair amount of risk across Europe, across Asia, on and on?
If you think about the global footprint, you can draw parallels to where the largest pools of volume is.
That typically correlates into our risk -taking.
In terms of saying that our largest risk exposure has always historically been the US, just simply because the volumes here in the US have been the greatest.
An interesting market that we're looking at and exploring and have some exposure in is also the China markets.
They have a very large, deep equity market, less on the derivative side.
But that is essentially how we think about our exposure from a risk standpoint.
Volumes first, that should equate to the alpha pi being the greatest.
And then our role is simply mining that alpha and then extracting alpha from those markets.
Okay. And then let's just flash forward to the current day.
There's a lot going on in the world.
Yes, there is. We have this upending of a traditional political order.
We have a very disruptive set of technologies in part colliding in real time.
We have a very concerning dynamic geopolitical backdrop.
The VIX is at 15. How do you square that circle?
I square it because if you think about what is trying to be accomplished for this new administration, you have on one side a very pro -growth, pro -business agenda, which you imagine would be constructive for asset prices.
The way that the agenda is being formulated and being presented is unconventional.
And that's, I think, the push and pull of what markets are trying to digest.
If we're sat at this table in three years time and we look back as to where we were sat here today, I imagine that we're going to look at one another and say, well, that was pretty obvious.
Why didn't we do that?
Why didn't we have more of that?
But because it's an unconventional, unpredictable manner of how policies are being implemented, I think that can be confusing and draw anxiety from the marketplace.
So if you didn't have that, you could maybe make the case that the VIX could be lower because clearly President Trump's policies and campaign pledges were very pro -growth and very business friendly.
And so you would imagine that would be supportive of risk assets and thus less volatility in the system.
I also think that there is an enormous amount of dispersion.
Which is a big business for you.
Which is a big business, where one day you have a stock or a sector that perhaps gets mentioned and that can cause terrific volatility, but it's stock or sector led, and that is a not necessarily at the macro level.
So not to get too technical, but clearly realized correlation is extremely low because you've had an awful lot of dispersion across different sectors, different stocks, et cetera.
But ultimately the indexes just haven't really moved that much.
You've had big moves across the different sectors and stocks, but not necessarily that hasn't translated into big index led moves here in the US.
I want to ask one question, which is, I think at your core, you are still a risk manager, you still retain that trading instinct, the risk management instinct.
You're running a big business.
You have many people working for you, but you wake up August 5th.
I'm not sure where you were.
I was in the middle of nowhere.
I was 20 miles from the Arctic Circle and I thought, oh, this will be interesting.
And the VIX is at 65.
I presume you kind of take off the CEO hat for a moment and you put on the head of trading, head of risk management hat?
Yeah. The way I try and describe it is our business is a large casino and people come in to the derivatives casino and our odds are 51 -49 on a regular day.
When you get those types of events of the VIX moving at that level or distress going through the market, you have the ability, you have, the odds change.
And the odds go to 55 -45 or 57 -43.
And so I just encourage my teams to say, we want to play more because the odds now are more in our favor.
For whatever reasons, there's more alpha available.
And so you have to trust your process.
You have to trust your infrastructure your systems you've got to trust your instincts to be able to bet more and to be able to and bet meaning that play offense play offense yeah and put risk on yeah and that is a still a work in progress because it's difficult to do that when the victim's at 65 sure
humans are human humans are like let's shut the casino down right right i don't play because you don't know.
You just don't know.
Sure. I'm super curious what the answer to this question is, because again, I've known you a long time and I would have guessed a good bit of what we covered so far, but I have no idea how you're going to answer this question, which is away from the hedge fund community.
One of the biggest themes in recent years has been the rise of private assets.
Yes. Private equity, of course, venture capital, of course, and more locally private credit.
Yes. Does it matter for what you do?
Does that create opportunity or challenges for what you do day to day?
It's kind of the after effects.
So I think the private industry has done an unbelievable job, has delivered outsized performance in certain areas, but it's a different part of the portfolio.
I think some of the issues that we see historically over these past two, three years, the hedge fund industry and the private industry are competing for the same dollar.
And we, the hedge fund industry, wants to be able to demonstrate to the end investor as to why we should play that role within the portfolio.
And the private industry is doing exactly the same.
I think over these past two, three years, there's just been a conversation, a dialogue around institutional investors around this notion of liquidity.
And so I think there's a dialogue, an ongoing dialogue of saying, all right, how much liquidity do we need within a portfolio, an institutional portfolio?
And that impacts Capstone in a couple of ways.
One, you've seen hedge fund allocations, and Goldman wrote about this in a great piece that you just put out, that because the privates are not distributing as much over these past two, three years, that impacts allocations across the broader sector.
To everything else.
To everything else.
So we've seen some of that occur.
And then secondly, we've engaged with institutional ambassadors around, how do you think about liquidity in your portfolio when you do have a large private allocation, and you are running these assumptions of saying, okay, if you do have a drawdown, what do you think your net distributions.
