Before 2008, few in the financial world had heard of Charles Ledley and Jamie Mai’s Cornwall Capital. Then in 2008 and 2009, Cornwall shot to fame when the hedge fund’s managers turned a $15 million investment into $120 million by betting on the failure of the subprime mortgage market. The hedge fund returned a whopping 297.7 percent in 2007.
Several years later, Charles Ledley and Jamie Mai were profiled in Michael Lewis’ book The Big Short. And last year, the duo became near household names when The Big Short the film opened in cinemas worldwide.
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Charles Ledley left Cornwall Capital in 2009 and joined Highfields Capital Management in 2010 where he apparently still works. Meanwhile, Mai stayed at Cornwall, and the fund continues to generate impressive returns for investors to this day.
Cornwall Capital: Outperforming using fat tails
According to a recent investor document, a copy of which has been reviewed by ValueWalk, between January 2003 and April 2011, Cornwall Capital achieved a compound annual return of 42.5% net for its investors. The old fund closed down in April 2011 and a new fund; the Cornwall Master Fund has continued on its legacy achieving compound annual returns of 4.1% net since May 2011. The hedge fund is about flat this year.
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According to the presentation, Cornwall invests along a) the probability spectrum and b) the liquidity spectrum. Risk management is at the core of firm’s strategy. Unlike some hedge funds which will follow a key theme or particular asset class, Cornwall seeks to build a portfolio isolated exposures to uncorrelated and idiosyncratic risks. What’s more, the fund rarely uses leverage.
But it is the probability and liquidity spectrums that underlie Cornwall’s investment strategy that are fascinating.
The example, the fund separates potential opportunities across the probability spectrum. Those opportunities with a low probability of playing out are only acceptable if possible returns are multiples of the initial investment. Tail risk must be fat (a fat tail indicates that there is a probability, however small, than an investment will move beyond three standard deviations).
Moving up the probability chain, other forms of mispriced optionality with the probability of a positive outcome sit in the middle of the chain. Special situations and deep value opportunities with a high probability of pay-off sit at the top of the chain, and these investments are based more on directional views than market inefficiencies.
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Cornwall‘s also invests across the liquidity spectrum, which gives the fund is scope to buy numerous different types of assets including liquid assets such as small cap equities, exotic options, private equity-style deals and real assets. At the liquid end of the spectrum, the fund can buy FX, commodities, rates and large cap equities.
Of course, Cornwall’s most famous trade was the fund’s subprime mortgage short and this trade exemplifies how Cornwall’s strategy is designed around finding opportunities across the liquidity and probability spectrums with fat tails.
Cornwall put on a similarly structured trade in 2012. This time the fund bet against the euro, at a time when the Euro area crisis looked to be receding despite the fact that the structural reasons why the crisis developed in the first place went unattended. Cornwall short the euro with long-dated options that would make 8.7 times the fund’s capital if the EUR moved back to parity with the USD. The only capital risked in this trade was the premium paid up front for the options.
Cornwall Capital: Long-term fat tails
The strategy used by Cornwall to achieve its outstanding results over the years warrants further research. Unlike the majority of the most high-profile hedge funds, Cornwall’s desire to seek out fat tail events for minimal risk has resulted in impressive long-term results. Rather than chasing quarterly performance figures, Cornwall is looking to preserve capital while taking advantage of the market inefficiencies that have sprung up due to the market’s short-term nature.
By taking a long-term approach, the fund can pay cents today for an investment that may yield a return of multiples on capital in a few years’ time. This patient approach should help Cornwall continue to rack up profits for investors for years to come.
This article was originally published by ValueWalk.
Photo: Jim Makos