00:00You do know a thing or two about risk.
00:02You write that math sets a speed limit on how fast a portfolio can compound.
00:06What is that math?
00:07Take us to Bell Labs and take us to 1956.
00:11Thank you for having me, Carol.
00:13Yeah, so this is John Kelly from Bell Labs, a physicist, also a fighter pilot and a bridge
00:20player, a really fascinating guy.
00:23And he discovered that, you know, most people assume that taking more risk means you increase
00:30the possibility of very good and very bad outcomes.
00:33But what he discovered is there's a limit.
00:36And beyond that, all you do is increase the probability of very bad outcomes, the Kelly
00:43point.
00:43And for those of you who are familiar with his work, probably in gambling context or investing
00:49context, the optimum is half of the Kelly limit.
00:52You know, you go halfway to the cliff and that's where you get your maximum growth.
00:57439% under any reasonable economics, any analysis.
01:02You know, we only have partial information about situational awareness.
01:06We have a 13F from April that doesn't have the shorts.
01:09We have, you know, Wall Street trader chatter.
01:12But any reasonable suggestion says 439% meant they were well over the Kelly limit.
01:19Meaning sooner or later, you have this happen to you.
01:22You blow up.
01:22Could be years.
01:24Could be tomorrow.
01:25Aaron, the column's about situational awareness, but it's also about the time period that we're
01:29in.
01:29And you referenced what's happening in South Korea and specifically with some of those
01:33levered ETFs and the chip names there.
01:35To you, does this illustrate sort of where we are in maybe a market cycle, a hype cycle?
01:41What does it tell you?
01:45Well, it's, I'm in an AI bolt myself.
01:49And, you know, I have some considerable investments in AI.
01:53Nothing we're talking about today would affect that.
01:56But having a long-term vision that AI is going to be very big doesn't give you a reason to
02:04take
02:05unlimited risk.
02:06And whether we're talking about South Korean retail investors, for that matter, New York
02:10retail investors, or the situational awareness fund, you have to think about the long-term.
02:17You have to think about, do I survive long enough to collect on my bets?
02:22So, I have a question for you.
02:25You know, investment folks, right, and companies often have, you know, risk managers.
02:32And I understand, you know, so, so.
02:35He's laughing right now.
02:36Am I wrong?
02:36Is there not someone to say, okay, you're in over your skis here?
02:41You know, like, so what's your read on this, this firm?
02:46I mean, it's still a $10 billion hedge fund.
02:48So, it's not like it's collapsed.
02:49And Citadel was happy to take, you know, but we understand that that's what they do.
02:53But I don't know.
02:54Like, how do we kind of step back here in terms of internally what this company is doing or
03:00this hedge fund is doing?
03:02Well, okay.
03:03So, Citadel has tremendous risk management, has some of the best risk management on the
03:06planet, which is why they're in a position to do this kind of thing.
03:10I don't know anybody at situational awareness, but the fact that they had either four or seven,
03:15I've seen different media reports, total financial professionals, makes me suspect, and plus their
03:21investments, make me suspect they did not have a risk manager or did not pay attention to him or did
03:27not
03:27have a qualified one because they're, it just not, does not seem like a risk managed portfolio.
03:33And all of the public statements we've heard from them only mention expected return, you know, future outcomes.
03:40None of it mentions risk.
03:43So, yes, they should have had a better risk manager.
03:46And that $10 billion is pretty misleading.
03:49First of all, I think that they're still carrying Anthropic at $5 billion.
03:53I don't think they've marked it down at all from its peak, and it's certainly worth less than that.
03:59Second, you know, they started the year at $1.5 billion, we think.
04:04They grew to well over, you know, $10 billion.
04:08And so I suspect most of the investors in SA on a dollar basis have lost quite a bit of
04:15money.
04:15If you were in January, you know, if you were part of that $1.5 billion, you're still up, I
04:20think,
04:2030% for the year, Wall Street Journal reported.
04:23But most of the people got in closer to the peak and are probably well underwater today.
04:29We're speaking with Aaron Brown, columnist for Bloomer Opinion, former chief risk manager at AQR
04:35Capital Management, also the author of Wrong Number, How to Extract Truth from a Blizzard of
04:39Quantitative Disinformation.
04:40I like that you brought up that private stake in Anthropic because I don't want to give the whole
04:44column away, but you, and I encourage everybody to go read it.
04:47I was just sending it around to some guests who've joined us in the past.
04:50You make the point that the Anthropic investment, like it makes sense that they still have that
04:54because they couldn't, they couldn't take margin on that.
04:58They can't transfer shares of that.
05:02So it's like at the end of the day, it's sort of the safest thing for them because they
05:07couldn't bet against it.
05:09Well, they can't lever it.
05:12There are people who will lend you money against it, but they won't, they're not daily margin.
05:17So you're not getting the kind of leverage they had for public investments.
05:20And it's possible that they didn't lever it at all.
05:23My guess is they didn't.
05:24You know, if you have public stock, you're going to lever those.
05:27You don't have to go to your private.
05:30But yes, a company like Situational Awareness, with their approach to the market, they should
05:35be making private investments and not levering them.
05:39What about the banks that were lending the money?
05:41Like what's the due diligence on that?
05:45And they were well-known banks.
05:46We keep citing like JP Morgan.
05:49I'm just curious how that typically works out.
05:54Well, it typically works out like this one did.
05:56They get all their money back.
05:58Yeah.
05:58Okay.
05:58You know, the due diligence ahead of it, Aaron, like, do they just, is there something
06:03that they look at ahead of it in terms of, yeah?
06:08Yes.
06:08Yes.
06:08They do that very carefully.
06:12And Archegos was, you know, a couple of years ago, that was the exception.
06:16That was where they all got burned.
06:18Because they went ahead over their skis, as you put it.
06:23They went ahead.
06:24This is exactly how it is supposed to work.
06:26The banks always should do okay.
06:29And what they were looking at is they were looking at the market for this stock.
06:32They were, they knew Citadel was around.
06:34They knew there were other people around who would, you know, be in a position to buy
06:37on a dip.
06:38And they quickly got out, you know, before, before they got hurt.
06:43And, and as I say, that's how it's supposed to work.
06:46And that's how it usually does work.
06:47That's why these companies are so big and rich.
06:49But you also make the point in the piece that Citadel learned this lesson the hard way.
06:53Like they're looked at right now as coming in and swooping in at, at this time.
06:57But post-2008, they suffered some, some serious losses.
07:02And, and AQR did, AQR in 2007 did as well.
07:06Yeah.
07:06So, so yes, risk management is a lot of unhappy experience, but learning from experience.
07:13So, okay.
07:13So hindsight is 20, 20, if, if this, if this portfolio, and again, we, we don't have complete
07:21information, like you said, this is, this is based around what has leaked and 13 Fs, but
07:25what would have been the right way to build positions in companies that, that you believe
07:31in that wouldn't have overexposed them on the downside?
07:38Well, okay.
07:38So situational awareness, the investment thesis is that AI is going to be gigantic, is going
07:44to, you know, I won't say take over the world, but, but it's going to be bigger than even
07:50most of the optimists think.
07:52But it has no thesis, at least as many of the public statements about the path to getting
07:56there.
07:57So you have to think about that through and say, what are the scenarios where we're right,
08:01but we don't get to keep our positions.
08:04It also has, I think people are not aware of how complex its positions are.
08:08Again, this is looking at the 13 F without the shorts, but we can see they're betting
08:12against a lot of these companies.
08:14They're picking and choosing.
08:15And, and so they've got longs and shorts and they've got a lot of puts on.
08:19So they're betting certain segments will do well and others are going to get beaten out.
08:25So this is a very complex bet.
08:27So you have to think, okay, what's the situation in which we're right, but what's the worst point
08:32between now and then?
08:33And can we survive it?
08:35It doesn't appear to me that they were asking that question or they weren't, you know, taking
08:39it seriously enough.
08:41I want to wrap up with, you know, you said earlier, Aaron, that you are an AI bull and
08:46you have positions, um, situational, um, awareness.
08:50We were trying to figure out, is this kind of maybe a coal in the canary mine when it comes
08:54to the AI trade and narrative?
08:55What would you say?
08:57It's not?
08:59No, no, I don't think so.
09:01I mean, you know, we had a pullback in AI and, uh, you know, a lot of people got hurt,
09:05but really the only headlines disasters are the people who were over levered, either the
09:11ETFs or situational awareness.
09:13Most of the investors are there for the longterm.
09:16You know, you don't see a huge sell-off.
09:17I don't see anybody changing their mind about AI.
09:20Um, you had to expect, I mean, I mean, these stocks are extremely volatile and the events
09:25of the summer have been, you know, pretty much normal volatility for this sector.
09:29So if you were investing sensibly in AI, the summer was not an unpleasant experience for
09:34you.
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