Invest Like the Best with Patrick O'Shaughnessy
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: Say more about that. [00:00:00] S1: My first job out of college was at Enron. I started there when I was 21 years old in 1995. It went bankrupt in late 2001. So then I'm coming out and I'm trying to figure out what to do. And I had a bunch of options. One is I could have stayed with the Enron trading floor, which ended up getting moved to UBS. I decided I wanted to do something that was a little bit more entrepreneurial and ended up deciding to start my own hedge fund. I had the classic hedge fund 2 and 20 structure. There wasn't an intermediary between me and the 20%. I was getting the 20%. I had the best, or as good as, economics as almost anybody in the business. Then we had very good financial returns early on. So that did two things. Number one, there was a lot of retained earnings and new investors came in. So we had a lot of risk capital. Second, we had a very good investor base that trusted the team I had built. Whenever we had a down month or a down time period, which we had, they weren't calling to redeem. They would call up and say, do you need more capital? Because we had earned their trust and we had done forced distributions along the way. I had set up this really powerful seat where I had good economics, so I could hire the best people in the business that I knew of. We had a lot of risk capital, and had a very solid and stable investor base.
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: I like this concept of developing the best seat in your industry. Are there any other interesting or useful components to that? If someone is listening and they're an investor, or even just a normal founder or business person, about setting up the best structural advantage in a seat, is it information flow? Is it other stuff? I love this concept. [00:00:00] S1: We started at 2 and 20. We did very well and had more demand to invest than we had capacity. We raised the fees over time and ended at 3 and 35 by the end. That allows investment in the business. You can build up a fundamentals team that's best in the business, because you can just pay them more. You can go do side projects, like trying to get proprietary data sources that give an advantage. You can pay the trading team, and the mid- and back office more money. Everything in the business starts to work and you have this sense of excellence around the firm, and that makes everybody better. We were able to develop a proprietary trade entry system and position management system. So, things that you don't necessarily think about, but are extraordinarily useful. Being able to buy any and all data, come up with proprietary data sources, have the best people trying to translate that raw data into something useful and build the best fundamental models in the business. I think it all becomes part of the flywheel. [00:00:00] S0: So really, scale. It's the redeployment of your scale that let you do all that and get into all these fine-grained ways that you could be better than your competitors.
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: So really, scale. It's the redeployment of your scale that let you do all that and get into all these fine-grained ways that you could be better than your competitors. [00:00:00] S1: Yeah, I think that's right. [00:00:00] S0: Can you tell me about the baseball card business that you built in high school? I'm curious about it because I always wonder where the initial spark comes from. You mentioned the importance of passion and that you just fell in love with energy markets. I'm curious to trace why you were entrepreneurial in the first place, what the formative things were, maybe where a chip on your shoulder came from, to the extent there was one, in hearing about that business. But then also hear the story between that and the discovery of passion for the energy market specifically.
· John Arnold
[00:00:00] S1: I was always entrepreneurial. I always wanted to make a dollar. As a 13, 14, 15-year-old kid, you have limited options, and I didn't really want to work retail because you weren’t going to make very much money doing that. I was in high school in the late 80s, early 90s, and this baseball card boom was happening. I remember, even in middle school, first getting started and introduced to baseball cards. It was when it was really starting to take off around '87. It became clear to me – I guess in retrospect, this is a really interesting kind of financial instrument that’s very volatile, that information on pricing is not very uniform across the market, and there were a lot of geographic price differences that were happening. I managed to talk myself onto this bulletin board of baseball card dealers back in the late '80s, and you had to get some references, and I’m like 14 or 15 years old, and I somehow finagle myself to be on this bulletin board, which is when internet commerce was just getting going, and they just had this wholesale system that was real-time pricing, in effect. You'd have people in New York trying to buy hockey cards, and people in Texas were trying to sell their hockey cards because there wasn't much demand for them. There were these arbitrage opportunities that got created. I know this from this bulletin board, people in Montreal or New York or Buffalo were willing to pay X, and I can buy these at Y and make that money. So I started doing that. The sports card business started to boom, so there was more and more money coming into it, more and more cards. A lot of the dealers in and around Texas weren’t caught up on day-to-day, week-to-week price changes. Oftentimes they had cards that were more valuable on the west coast or east coast or in the north. So I would just run around every weekend to a bunch of card shows. I was living in Dallas at the time, but would travel to Houston, Louisiana, Oklahoma. I started getting on planes when I was 16 and going to big card shows around the nation. I just always had this sense of value, of what something was worth at the time. It turns out there were a lot of similarities between doing that and the trading. I was, in a way, doing market making in sports cards. I was taking advantage of arbitrage opportunities in sports cards.
· John Arnold, Patrick O'Shaughnessy
Knowing what every product is worth at every moment stuck with me. And that was my mantra when I was trading gas, is that I knew what every month was worth, better than I think anybody else did, and I would do that – I knew that every moment of the day. To do that, it takes focus. Just sitting there and staring at the screen and listening to every trade that happens in the market. All day long, every day. It takes that work and intensity. [00:00:00] S0: Can you describe the actual instruments that you were trading? When you were trying to put positions on and take them off, what were those positions? What were they in, on average? I want to get into some of the nitty gritty details to give people a sense of how far you had to go to get an edge in this world, as an analogy for how far you have to go to get an edge in anything. This was the thing you enjoyed, and I want to come back to why you were so passionate about it in the first place. But what were you literally trading in those days?
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: Can you describe the actual instruments that you were trading? When you were trying to put positions on and take them off, what were those positions? What were they in, on average? I want to get into some of the nitty gritty details to give people a sense of how far you had to go to get an edge in this world, as an analogy for how far you have to go to get an edge in anything. This was the thing you enjoyed, and I want to come back to why you were so passionate about it in the first place. But what were you literally trading in those days? [00:00:00] S1: It was primarily futures, and swaps that were a look-alike to the futures. I traded natural gas. The hub for natural gas trading was Henry Hub in Louisiana. There would be price differentials between what gas was worth in Louisiana versus gas in Pennsylvania, or in West Texas or Colorado, for instance. That's basis. I did that for a small part of my career, those price differentials between one point and the hub in Louisiana. But most of my career in trading was trading what we call the fixed price of natural gas. This is, if you're watching CNBC and on the ticker, it has a gas price. That's what I was trading. [00:00:00] S0: In a given day, how much volume and activity would there be? How many key decisions would you make in a given day?