The Hedge Fund Manager with Extraordinary Ability

Matt Peluse is the CEO of Esulep Management, a Chicago based Hedge Fund and the #1 absolute returns manager in the world. Prior to holding that position Matt was an equities and derivatives trader at a Chicago based proprietary trading firm. Matt has traded just about every market in the world and at one point was 1 percent of the volume of the markets he traded. He is an incredibly gifted investor and trader that can whittle the most complex subjects down to easy to understand tidbits. His hedge fund has won multiple prestigious awards including the Pinnacle award, Prequin award, BarclayHedge award, and was a 5-star Morningstar manager.

In this discussion, we talk about trading war stories, his approach to the financial markets, his secrets to keeping calm when under extreme duress, options as investments, the current state of the markets, and how he became the #1 absolute returns manager in the world.

Whether you’re trying to become a better financial participant, the best version of yourself, or a better business owner this episode is for you.


Links From the Episode:

Show Notes:

  • Multi-University Micro Scale Rockets Project [5:30]
  • Princeton’s eating Clubs [7:12]
  • Running a business like a business [8:45]
  • First involvement in financial markets [9:55]
  • What intrigued you about trading? [12:15]
  • The failed mentality in trading/investing [15:18]
  • What is a proprietary trading firm? [16:45]
  • How did you create your first trading strategy? [18:20]
  • Trading can eviscerate your mental conditioning [23:20]
  • Trading in the pit vs trading on the screen [25:20]
  • An example of calm under extreme duress [26:20]
  • Preparation is everything [30:45]
  • Pit trading [33:20]
  • How the financial markets worked [36:45]
  • Starting a hedge fund in 2007-2008 [39:55]
  • Address risks first [42:55]
  • Public psychology in financial markets [45:42]
  • What are you seeing in today’s markets? [51:06]
  • Why is your hedge fund different? [57:35]
  • There is no edge in financial news/information [1:01:57]
  • What is an option? [1:03:05]
  • Why do hedge funds get such a bad rap? [1:10:08]
  • How do you select a hedge fund manager? [1:13:40]
  • Rules for successful investing [1:17:21]
  • Best advice received [1:18:27]
  • Resources to further educate [1:19:28]
  • Would you change anything? [1:21:00]

The Hardest Part is Taking A Step Back


Whether you like Tim Ferriss or not is not important. Tim wrote a really insightful blog post recently about why he is stepping away from investing in startups. What intrigued me was why he did it. As a trader and investor I can empathize with what he is going through. Whether you’re an investor in startups or a trader in the public markets, stress is your enemy, but almost impossible to completely eradicate. Tim has a number of great points in this blog post. I will attempt to provide some of the most relevant to this conversation.

FOMO results in “B” Player Status

As an investor/trader many know that the “Fear of Missing Out” is strong. You hear of all the good trades and none of the bad. You fear that you are missing out on trades or investments that other people are making gobs of money on. The same goes for startup investing. If you are an angel or venture capitalist “FOMO” is just as strong. FOMO creates stress, terrible stress. This stress takes you out of the game and results a “B” investor status. Tim realizes that because of FOMO he is investing in more startups than he should. He’s becoming a “yes” man, which becomes an overwhelming experience. As a trader or investor I compare this issue with not being able to choose the investment or trading strategy that best fits your character. As an trader/investor your goal is to make money. When you see others make money or hear of these terrific trades, you start to wonder if you’re missing out. Should your trading/investing strategy change? It goes back to the phrase, keep it simple stupid. If you try to take advantage of every “opportunity” available you get stuck in the mud. You get buried alive. You get stressed out. You can’t focus. Your mind is too busy. Public markets give the trader/investor opportunities daily. Stay focused on what you’re good at, don’t worry about what others are saying, and maintain your edge. Don’t become a “B” player.

Does a large guaranteed decrease in present quality of life justify a large speculative return?

This is a terrific question for any trader/investor. I guess another way to ask this question is whether you would take the trade if the stress of the trade created insomnia, lethargy, loss of appetite, and/or moodiness, but the potential outcome could change your lifestyle. I would argue that this investor is on the path to destruction if that trade gets placed. I’ve been there. I have taken positions where the stakes were much higher than my comfort level. That level of uncomfort will almost always result in a negative outcome. There are always going to be individuals that are comfortable in that type of scenario and can think logically in unbelievably stressful times, but those are few and far between. Tim makes a terrific point in saying that you should always know your ROI which comes in the form of cash, time, energy, or otherwise. “An investment that produces a massive financial ROI but makes me a complete nervous mess, or causes insomnia and temper tantrums for a long period of time, is NOT a good investment.”

Leverage your strengths instead of fixing your weaknesses.

If this statement doesn’t make you think as a trader/investor you’re missing the point. Tim states, “Don’t push a boulder up a hill just because you can.” It’s absolutely true, but most “investment/trading guru’s” will push their methodology because it may have worked for them or a few others. Here’s the problem: the chance of that specific investment/trading methodology fitting your personality is pretty damn low. Before putting money on the line you should be seeking out your strengths and weaknesses. I have been a trader and investor for over 15 years and many “trading gurus” will tell you that eliminating your weaknesses will create success. This is a bunch of baloney. I know that my strengths are not geared toward short term trading. So, why should I trade short term? What benefit will that provide me, except years of attempting to change core behaviors to fit the mold. Why not understand and leverage my strengths? That is your edge, right? Understanding this concept will increase your quality of life and ROI as an investor.

Know Thyself.

This statement dovetails nicely and is somewhat related to the previous point. Many traders/investors are completely consumed by their profession. They’re usually an all or nothing type of person. It’s difficult to find the shut-off switch. Personally, I have realized that if and when I find it hard to shut down and focus on something other than investing, I need to step back. We all have a tendency to get completely absorbed by something and it’s difficult to pull yourself away. We don’t even realize our stress is through the roof. So, what do we do to combat this “disease”? Stop. Stop trading. Stop investing, until you can take a step back and see how it’s effecting you. I give Tim a lot of credit. He has been an extraordinarily successful Angel investor. He realized that he is an all or nothing guy. He knows, in theory, that he can’t follow through if he tells himself he will only invest in two deals a quarter, which he has tried to do. If he wants to slow down and create a better quality of life, he needs to stop for a breather. He needs to stop investing, so he can reboot. What’s the worst that can happen? Ask yourself that question, and write down the answers.

I was always told, “take your time, the market will always be there when you get back.” It’s calming advice. I believe the hardest part of being a trader/investor is the ability to step back and see the bigger picture. This profession can eat you alive faster than any other profession in the world. I don’t believe that there is another profession in the world where it’s absolutely imperative that you know yourself inside and out in order to be somewhat successful. Make sure investing is creating the lifestyle you always wanted, not the stress that buries you alive. Your quality of life is positively related to your success. So, if you need to take a step back, listen.

Are There Rocky Seas Ahead for Crowdfunding and Startup Investing?

There’s no question that Crowdfunding has become a big business. The 800 pound gorilla is Angelist, which was founded by a very good VC himself, Naval Ravikant. Angelist has become more than just a crowdfunding platform. It’s now a place where startup employers and potential employees can tie the knot. Without picking on a specific Crowdfunding platform, I believe there are rocky seas ahead.

Crowdfunding has recently exploded in popularity, especially with the passing of the JOBS Act. Now, any investor, qualified or not, can invest in private companies. This both is a positive and a negative. The popularity of crowdfunding and the ability of any novice or seasoned to invest in a startup feels eerily similar to the late 90’s/early 2000 day trading frenzy. Electronic trading was new and provided unparalleled access to the public markets for any seasoned or novice trader. It opened the floodgates and no one really knew what to expect. Well, we knew what to expect when the majority of those novice traders and many seasoned traders got wiped out when the tech bubble burst. I saw it first hand.

This similarity pushes me to believe that it will take a similar occurrence to understand the negative consequences of this new-found opportunity. Personally, I think it’s an amazing way for smart, seasoned investors to invest in early or late stage startup companies. It’s also a great way to find successful startups and invest alongside some big name VC’s. Here’s the problem: there’s going to be those novice investors that think they can make a quick buck, just as we saw in the day trading tech bubble. Unsophisticated investors are going to pile money into these private companies without understanding the risks. It could be because they feel the safety of investing alongside a big name VC. Whatever the reason, the result is going to be the same: unsophisticated investors are going to lose a lot of money because they don’t do their homework.

Private startup companies are raising stupid amounts of money. The valuations of many are sky high. Investing in startups is not for everyone. The investing time frame can be anywhere from 8-12 years. It’s not a get rich quick scheme. Mark Suster blog has a terrific explanation of the current state of the startup market. He says:

“If the market is driving up prices beyond intrinsic value the main new entrants to the market that have taken a less rational view of historical prices are a series of “non VCs” including corporate investors, hedge funds, mutual funds and crowdsourcing. Note that I’m not absolving my industry, venture capital, from bad behavior. I’m merely pointing out that price drivers are more strongly correlated with outsiders. On the chart below, 78% of the rounds of 80 $1bn+ companies were led by non VCs.”


Mark goes on to say, “To give you some perspective of how quickly we’ve created a “subprime Unicorn market” (as Michael Moritz called it) consider that in the last 18 months in the US alone we’ve gone from 30 privately held technology companies worth more than $1bn (already considered high by some) to more than 80 companies just 18 months later. Either we’ve discovered magical beans and elixir or perhaps we’ve gotten ahead of ourselves on valuation.”

Just remember that history repeats itself. There’s always a boom and bust cycle. Today, there is an overvaluation of private companies. The seasoned investing pro’s know that, but all the unsophisticated public investors just see dollar signs. This is exactly the type of scenario that occurred in the day trading tech boom and occurs in any other investing marketplace. Unsophisticated investors follow the trail of money for dreams of grandeur. Most of those individuals will blow out just as many day traders did during the tech bubble. I feel that this scenario will play out sooner or later with the startup world. The investing public will keep pouring money into these companies until the next bust. The government will rethink regulations associated with crowdfunding and startup investing. It usually takes a catastrophic event for everyone to understand the risks. I guess humans will be humans…

Interview with Students of “Leadership In New Ventures”

Last week I was interviewed by a University of Colorado student. His assignment was to interview an entrepreneur that was of interest to his group for a class titled, “Leadership in New Ventures.” This is the first time I have been interviewed and recorded for a graduate class. The questions were expansive and interesting. It was a lot of fun. Below you’ll find the entire recording of the interview. We talk about everything from mission statement to leadership to ultimate goals. Hopefully it gives a little insight into an entrepreneurs mindset. Cheers!

Recording – October 2015

The Day Medical Marijuana Made Me a Believer.

This is not my typical blog post, but I need to tell my readers a short story. Last week my mom and her boyfriend were visiting us in Denver. A couple years ago her boyfriend was diagnosed with Ataxia. The definition of Ataxia is not relevant, the effects are. The largest effect is loss of motor control. This includes speech and bodily movements. The effects are very similar to Parkinson’s. Medication and therapy has had no effect on the aggression of his symptoms. As a result, I started researching marijuana and Parkinson’s. Surprisingly, there are a number of studies showing increased motor function in the Parkinson’s patients that use marijuana.  After researching the studies I met with a few people well-versed in medical marijuana and types that combat Ataxia’s terrible effects. As a disclaimer, I’m no Doctor and don’t hold myself out to be one, what I’m about to say is for informational purposes only. My hope is that others are able to benefit from what I’m going to say.

After meeting with a number of medical marijuana professionals the conclusion was to have my mom’s boyfriend try medical marijuana. The oil was comprised of 50% THC/ 50% CBD, which was based on the symptoms he was combating. Typically, his speech is slurred and is very similar to speech you would exhibit if you were very drunk. The same goes with his ability to walk. His walking is unbalanced and his feet sweep the ground as though he is searching for his next step. Since it was experimental, we weren’t expecting anything dramatic. At best, we were expecting slightly better speech. That’s not what we got. Two minutes after taking the marijuana his speech was crystal clear. I mean crystal. It was as if he sobered up in minutes. We then asked him to walk around the kitchen table. Typically, we need to help him stand from the couch to his feet. This time he was able to stand from the couch and walk around the table, balanced without any foot shuffle.

If you were to tell me that smoking weed would produce results that I just witnessed I would tell you to stop hitting the pipe. After the fact, my mom’s boyfriend said, “this is the first time anything has ever produced a positive result.” Another positive side effect is that he was telling jokes and become more lively. It was an amazing thing to witness. Like I said, my hope is that marijuana produces the same positive effects to those looking for an alternative form of care for other serious illnesses.

Here’s a chart on symptoms and the part of the marijuana plant that combats those symptoms: Cannabis Chart


Exercise is Imperative for the Mind and Soul.

Henry Rollins

There’s a disturbing statistic from a new study that 25 percent of students report being bullied in the last year. Being born in the 70’s and growing up in the 80’s and 90’s, I remember those days. I was skinny, small, and had zero muscle when I started high school. Today’s society is different though. It seems as though everything is magnified, everything moves faster, and everything is so intense. My five year old son goes to kindergarten from 8:15 a.m to 4 p.m. In that time, he get 1.5 hours for play/exercise. The rest of the time is dedicated to transitions from class to class or study to study. That’s fucking intense and it scares the living shit out of me, honestly. There’s been quite a few studies related to exercise and mental health. All of us are keenly aware that exercise promotes positive mental health. This is even more so in kids. According to a study published online in the Journal of American Academy of Child and Adolescent Psychiatry,

“Physical activity is inversely related to sadness and suicidality in adolescents, highlighting the relationship between physical activity and mental health in children, and potentially implicating physical activity as a salient option in response to bullying in schools.”

An accompanying editorial, by Dr. Bradley D. Stein and Tamara Dubowitz of The Rand Corporation in Pittsburgh, states,

“…the evolving literature suggests that physical activity interventions appear to be potentially promising as preventative interventions for some children and adolescents at risk for developing mental health disorders and for augmenting more traditional interventions for children and adolescents being treated for depressive and anxiety disorders and attention deficit/hyperactivity disorder. The side effects of such physical activity interventions are likely to be more positive for many children than those of many other therapeutic interventions and potentially less costly.”

In 1994, Henry Rollins published a well known essay in Details Magazine called “Iron and the Soul.” It’s absolutely fantastic and I believe everyone should read it. For many of us, this essay hits home. He expresses everything that many of us felt in grade school and high school. The feelings related to feeling stupid, humiliation, fear, and aggression. Back in the day, exercise wasn’t as prevalent as it is today. In today’s world, these feelings tend to be more intense for kids. Exercise should be at the forefront at home and at school, especially in today’s society. The University of Vermont put out a news release that states:

“Across the U.S., nearly 20% of students report being bullied on school property. Bullying is associated with academic struggle, low self-esteem, anxiety, depression, substance abuse, and self-harm. Exercise has been widely reported to have robust positive effects on mental health including reduction in depression, anxiety, and substance abuse.

Using data from a nationally representative sample of youth who participated in the National Youth Risk Behavior Survey (CDC), a group of researchers…examined the relationship between exercise frequency, sadness, and suicidal ideation and attempt in 13,583 U.S. adolescents in grades 9-12. The authors hypothesized that exercise frequency would be inversely related to sadness and suicidality and that these benefits would extend to bullying victims.

Overall, 30% of students studied reported sadness for 2 or more weeks in the previous year; 22.2% and 8.2% reported suicidal ideation and suicidal attempt in the same time period. Bullied students were twice as likely to report sadness, and three times as likely to report suicidal ideation or attempt when compared to peers who were not bullied. Exercise on 4 or more days per week was associated with significant reductions in sadness, suicidal ideation, and suicidal attempt in all students. In particular, the data showed a startling 23% reduction in both suicidal ideation and suicidal attempt in bullied students who exercised 4 or more days per week.

Based on these findings, the authors concluded that exercise may represent a safe, economical, and potentially highly effective option in the response to bullying in schools.”

From personal experience, I can say that lifting weights significantly improved my mood and confidence in high school. Without having a no-nonsense military vet pushing me to become better, my mood would have deteriorated significantly. Each child should have a focus in exercise, whether it be gymnastics, weightlifting, or soccer. It’s imperative to their mental health and well being. Henry Rollins said it best when he said:

“Through the years, I have combined meditation, action, and the Iron into a single strength. I believe that when the body is strong, the mind thinks strong thoughts. Time spent away from the Iron makes my mind degenerate. I wallow in a thick depression. My body shuts down my mind.

The Iron is the best antidepressant I have ever found. There is no better way to fight weakness than with strength. Once the mind and body have been awakened to their true potential, it’s impossible to turn back.

The Iron never lies to you. You can walk outside and listen to all kinds of talk, get told that you’re a god or a total bastard. The Iron will always kick you the real deal. The Iron is the great reference point, the all-knowing perspective giver. Always there like a beacon in the pitch black. I have found the Iron to be my greatest friend. It never freaks out on me, never runs. Friends may come and go. But two hundred pounds is always two hundred pounds.”


Where Can You Find a Good Social Media Marketing Agency?

Online marketing and the companies that provide online marketing strategy will keep seeing their growth expand for years. It’s no secret that online marketing for your business is a necessity rather than a muse. Social media marketing is something that I have done my best to learn and become a pro at. Unfortunately, the time it takes to expand your audience and provide relevant content is extraordinarily time consuming. All small businesses run into a wall and must decide what specific responsibilities you feel comfortable handing off to a trusted partner.  In my case, I searched to find the best firm to “farm out” my social media marketing. Not only has it freed up my time, but it has increased the awareness of my brand significantly.

A couple weeks ago I was introduced to a firm, The Social Guerrillas, that specialize in social media marketing. Specifically, this firm focuses on Twitter and Instagram.  The basis of their service is to provide their clients with a way to increase overall visibility, a way to reach a new target audience, a way to speak to your current fans, and a completely safe way to increase followers. In order to test their product, they give each prospective client a free 5-day trial of their services to show what they can do for your company. Below are the stats for my company’s Instagram account for the 5-day trial that The Social Guerrillas provide. As a side note, these are not related to my wealth management firm. These stats are related to the CrossFit gym I own.

Start Numbers –  135 Followers; 206 Following

09/16/2015: 152 Followers; 195 Following;  85 Follows per day;  98 Unfollows per day;  108 Likes per day
09/17/2015: 234 Followers; 700 Following;  536 Follows per day;  31 Unfollows per day; 547 Likes per day
09/18/2015: 339 Followers; 1234 Following;  535 Follows per day;  1 Unfollows per day; 522 Likes per day
09/19/2015: 437 Followers; 1692 Following; 523 Follows per day; 64 Unfollows per day; 508 Likes per day
09/20/2015: 524 Followers; 1674 Following; 312 Follows per day;  332 Unfollows per day; 497 Likes per day
09/21/2015: 606 Followers; 1673 Following 392 Follows per day; 393 Unfollows per day; 405 Likes per day
;09/22/2015: 660 Followers; 1672 Following; 375 Follows per day; 378 Unfollows per day:  364 Likes per day

Total New Followers 525

If you have any experience with Instagram you know how difficult it is to increase your brand awareness with followers, especially targeted followers. After the 5-day trial I went through my list of followers and those that are following. I found that almost all of the new followers and following are relevant based on popular hashtags related to my industry or relevant based on geographical location. The short amount of time this firm had to create those numbers was staggering to me. It would’ve taken me months to create that kind of following, not to mention being completely absorbed by one responsibility.

In addition to creating a wider more relevant audience The Social Guerrillas will be interacting with followers via direct message in order to provide the most relevant followers with a discount code for memberships and apparel. So, hiring The Social Guerrillas allows me to focus on content and leave the online marketing to the pros. My ROI far exceeds what I pay for the service. It allows me to free up my time and focus on other more important tasks at hand.

I have no economic interest in The Social Guerrillas, but I feel that their service for my company has been so great that I wanted to throw their name out there for others to try. If you’re interested in contacting The Social Guerrillas, I’m happy to give you a direct contact. Just use my contact form on this website and I’ll shoot you an intro email.

5 Tips for Successful New Hire Onboarding

Metro State University and The Denver Metro SBDC partner to provide graduating business students with a real world case study. Under the supervision of a Metro State University of Denver professor and SBDC staff, graduating business students will conduct a strategic business analysis for my business in exchange for the opportunity to work on a real world consulting project. When Metro State approached me I thought it was a great opportunity for the students and would be a lot of fun for me. So, over the past couple weeks I met with two groups of 4 students each and answer a number of questions. There were a couple things that came out of that, but one in particular that made me ponder on how I hire successfully. Ultimately, your business lives or dies with the success of your employees and your hiring process. So, I jotted down 5 tips for successful new hire onboarding.

  1. The first Interview should not be formal –  When I meet someone for the first time I don’t like to talk too much about the business. I want to understand who the person is that I’m interviewing. The first interview should be informal. Make them feel comfortable. Ask questions about their background, their hobbies, activities, what they read, who they follow, their family, etc. This conversation should be over a beer or coffee. This informal interview tells me more about the person than anything else. I can tell right after this interview if this is the right person for our company.
  2. Provide an employee handbook – The biggest time saver for me when I hire someone, is to provide them with an employee handbook. This spells out our mission statement, vision, responsibilities, and expectations. This gives the prospective employee insight into expectations if they decide to come on board. It also provides them with a framework to come up with questions for me.
  3. Provide the prospective employee with current employees contact info – Some prospective employees want to hear about the experience right from the horse’s mouth. They may have intimate questions that they may want to ask someone other than the owner. The handbook may provide them with expectations, but how practical are those expectations? This gives them a platform to test those expectations to see if this is the place for them.
  4. Shadow an employee with similar responsibilities as the prospective employee – Allow the prospective employee the opportunity to shadow. Give them insight into how their day in and day out activities would look. This will give the employee a good taste of what to expect and will push them in one direction or the other.
  5. Have them read “Hot Seat” by Dan Shapiro before their first day – This gives them insight and advice into how companies have lived and died. I want them to take ownership. This lays the ground work.

These have been great for my business. It provides me with a repeatable process and weeds out the people that are just looking for a “job.” I need people I can rely on and can trust. These tips have created that framework.

So, What Do I Get For the 1%?

The way an advisor charges a client has been rehashed many times on a number of different blogs, so I won’t get too far into explaining each and every option. Recently, there have been some advisors bucking the norm. The norm for advisors has been to charge a percentage of assets under management. Some advisors have bucked this trend and have been charging a flat fee no matter how much an individual has under management. There have been some recent blog posts about why charging a percentage of assets under management is not in the best interests of the client. I agree and disagree to a certain extent.

In my mind to charge a fee based on assets under management aligns an advisor’s interest with the client’s interest. If the portfolio appreciates, the advisor gets a raise. If the portfolio depreciates, the advisor gets a pay cut. Pretty simple, right? Well, I believe the more difficult issue comes about when you look at what each client is receiving for the percentage they are paying for the management of their assets.

Let’s take an example. Mr. Smith pays his advisor 1 percent to manage his $500,000 portfolio, so he pays $5,000 per year for the services. So, what is Mr. Smith receiving for $5,000 he pays his advisor? Mr. Smith is receiving a portfolio of mutual funds that the advisor has researched and chosen and thus outsourced the management of the portfolio to these funds. So, for $5,000 Mr. Smith is paying his advisor $5,000 to be a manager of managers, be invited to play golf, and receive a call a couple times a year to stay in touch. This scenario plays out over and over again in the wealth management business. So, for the most part I agree with the argument that an advisor should be providing more for the fee he/she is charging their client.

Some firms have been incorporating financial planning into their pricing model, which provides a great value to many clients that are looking for that service. Financial planning can get very expensive and to provide that service as part of the management fee is a great value in my opinion. On the other hand, my firm provides a different service because my firm targets a very specific demographic: business owners and entrepreneurs. Financial planning is not the most important service that they are interested in being provided. We wear many hats for our clients. We can and should be thought of as investment managers, business consultants, tax strategists, and estate planners. These are the services that are most important to our clients. We provide value over and above just managing our client’s money. Our clients need someone to answer questions and provide relevant answers that relate to their business and effect their personal life. Some frequently asked questions are; What accounts should we open and fund to save on taxes? Who can you introduce us to that would benefit our business?  How should we structure our business going forward?  What assets should be held in trust as we become more successful? Can you review an investor deck and give me your opinion? Etc.

These are the questions we get asked and these are the questions we are prepared to answer. We try to provide the very best guidance for our clients. We work with our clients throughout their personal and professional lives. We are successful if they are successful. Providing our clients with these ancillary services allows us to be part of their team. If our clients were to go out and hire a firm to answer these questions or to help them to strategize, the out of pocket costs would be prohibitive for most and time consuming to find the right fit. We not only provide our clients the benefit of using our resources and capabilities to build their businesses, but we help them to cut the fat and simplify their personal and professional teams.

If you’re considering working with an advisor make sure you ask the question of, “what services are you providing for the fee that I’m paying.” If it doesn’t add up or if the ancillary services don’t fit with your needs, move on. There are some great firms our there that will fit your requirements, it just takes a little digging. Fees aren’t everything when you pick an advisor, but they are certainly a big factor when considering what you receive in return for the fee you pay. So, do your due diligence. There’s someone for everyone.

Skeptical of Robo-Advisors? You Should Be…

I’m an information hog. I love to read about the new technologies breaching the financial services industry. In fact, I usually request a demo of financial software if I think it’s unique. I have requested demo’s from JemStep, Schwab Intelligent Portfolios, FutureAdvisor, Motif Investing, Betterment, and so on. I wanted to understand how their software works and how portfolios are constructed. Many times the individuals that I spoke with couldn’t give me a very good answer as to how they construct their portfolios besides providing me with a blanket answer of diversification. Many state that their investment philosophies are backed by big names like Burton Malkiel, but fail to give me an understanding of how portfolios are chosen or how risk is measured. As a result, I made the decision to not provide a Robo option to prospective clients of my firm, but that may change.

Yesterday, I received an email from a small Robo-Advisor/Risk Assessment firm named RiXtrema. RiXtrema came out with a robo-advisor for advisors called BioniX. It looks at risk in a much more reliable manner. For instance, take this excerpt from the RiXtrema White Paper, which I highly suggest you read if your money is invested with a Robo-advisor.

“Robo-advisor methodologies are based on mean-variance optimization, which focuses on trailing variance as a measure of risk. Trailing variance is calculated from relatively recent history of the financial markets, usually a few years. Variance in financial models is simply an average squared difference between the average return and return on every date observed over some historic period of time. Thus it should be clear that when [the] market is trending up like we have seen over the past few years, the average return is positive and deviations from that average are relatively small. That is why in periods of prolonged market tranquility, trailing risk measures have dramatically understated market risk.”

Not to make things technical, but if you have some sense of what that statement means, it should give you pause with the current volatility in the market. The majority of Robo-Advisors will manage risk in this way. To follow up with another great excerpt from the white paper:

“In addition to the problem of understatement of risk prior to a crisis, variance based measures overstate risk following it. You can see that risk in our chart keeps climbing all through 2009 and, in fact, keeps climbing through 2011. As a result, investors that go to robos after the crisis will get portfolios that are now excessively light on stocks. Mean variance algorithms can be thought of as ‘buy high sell low’ strategies around crisis events, which is the opposite of what investors want. Imagine if an advisor had suggested that clients load up on risky assets prior to the Lehman collapse, but then after the collapse in 2009 started putting everyone in bonds. That would be precisely what should not happen, but that is what existing robo technologies are set to do. It is no surprise that the Fed no longer uses Value-at-Risk (essentially same as trailing variance) when talking about systemic risk, but focuses exclusively on stress testing.”

So, you’re telling me Robo’s will buy high and sell low? Yes, that’s what it’s saying. Think of it as measuring risk on a delay. It’s like getting delayed quotes when you’re trying to trade intraday. It’s worthless and you lose money. Why would you do it? My point is that if you decide to use an automated investment platform make sure you understand how they measure risk and how it constructs portfolios based on that risk. For the past 2 years, Wealthfront portfolios have gotten murdered. Wealthfront portfolios have no Treasuries. There’s nothing in the portfolios to soften the blow. Their portfolios have stunk the place up! A person with average risk tolerance still has 38% of their portfolio in foreign plus emerging stocks or bonds. I don’t know if you noticed, but it’s been quite the shit show in Emerging Market bonds and stocks.

Stay safe and do your homework. I’ll update this post once I demo RiXtrema.