Bigger markets, more alpha: Capstone’s Paul Britton on running a derivatives hedge fund

Capstone Investment Advisors: Origins, Evolution, and Strategy

• Founding Context: Founded in 2004 by Paul Brittain after identifying the options market making business as an escalating technology "arms race" that would likely result in a "winner-takes-all" outcome against firms like Citadel or Goldman Sachs Securities.
• Strategic Pivot: Brittain shifted focus from market making to building a global, multi-asset class investment firm (Capstone Investment Advisors) to capture alpha across asset classes while protecting against downside risk.
• Current Scale: The firm manages approximately $11 billion in assets under management (AUM) and recently celebrated its 20th anniversary, employing roughly 330-340 staff.
• Crisis Lessons:
  • January 2008: An "aha moment" where Capstone profited from volatility triggered by a European bank disclosure on MLK Day, proving the scalability of their strategy.
  • Q4 2008: A catastrophic failure due to a lack of rigorous risk frameworks, leading to significant losses and a fundamental restructuring of the firm's risk management protocols.
  • 2020: Validated the new risk framework during a period of extreme volatility, providing Brittain with confidence that the firm's processes were robust enough to handle systemic shocks.

Derivatives Market Dynamics and Alpha Generation

• Market Expansion: The derivatives market has evolved from a professional-only domain to a mainstream tool, increasing volume and participation; Brittain views this expansion as a positive driver for alpha generation.
• Alpha Source: Capstone targets unique alpha opportunities by analyzing derivatives usage patterns that differ from the average participant, rather than competing on pure volatility exposure.
• Geographic Exposure: Risk exposure is primarily concentrated in the U.S. due to the highest volume of trading, with emerging exposure to the deep equity markets in China, though derivative liquidity there remains lower.
• Liquidity Begets Liquidity: The firm argues that increased market volume allows for higher risk deployment and better price discovery, translating directly into higher alpha propositions for institutional investors.

Current Market Environment and Forward-Looking Views

• Current Volatility: The VIX currently sits at 15, reflecting a market digesting an "unconventional" and unpredictable pro-growth political agenda, which creates anxiety despite favorable policy promises.
• Market Dispersion: High sector and stock-level dispersion is driving volatility for specific assets, but this has not yet translated into significant broad index movement in the U.S.
• Central Bank Shift: Brittain predicts the era of coordinated global central bank intervention (2008–2020) is over, viewing the "Fed put" as having shrunk significantly.
• Future Elasticity: The post-central bank intervention era is expected to result in greater market elasticity, with fair value for the VIX potentially shifting upward (e.g., from 10 to 15) and correlations becoming less reliable.
• Active Management Tailwinds: Data indicates hedge funds outperformed 60/40 portfolios by nearly 2x on a risk-adjusted basis in the post-COVID era compared to the prior "zero bound" period, suggesting a favorable outlook for active management.

Capital Flows and the Private Assets Debate

• Liquidity Competition: The hedge fund and private asset sectors are competing for institutional capital, with private markets' lack of recent distributions impacting broader hedge fund allocations.
• Liquidity Overlay Strategy: Institutional investors are increasingly seeking hedge fund strategies not as tail hedges, but as liquidity management tools to handle capital calls from private equity drawdowns during market downturns.
• Value Proposition: Capstone positions its liquidity strategies as a premium service (costing 20-50 basis points) that enhances the liquidity profile of portfolios heavily weighted in illiquid private assets.

Organizational Culture and Operational Strategy

• Speed as Survival: The firm operates on a "fast-paced" culture where speed is critical; Brittain notes that moving too slowly allows competitors to overtake the firm.
• CEO Philosophy: Brittain prioritizes consistency and vulnerability as key leadership traits, believing that admitting a lack of understanding encourages a culture of continuous learning and trust.
• AI Integration: Capstone is aggressively pursuing a goal to save 50,000 labor hours by automating repetitive workflows, allowing staff to focus on higher-value tasks.
• Future Vision: Brittain views AI accessibility as a near-term game-changer, believing that within three to five years, the technology will fundamentally alter productivity and task allocation within the firm.

Key Personnel Insights

• Investor Skills: The firm identifies "process discipline" paired with "curiosity" as essential for world-class investors, emphasizing that no process is static and requires constant refinement.
• Inspiration: Brittain cites the late Jim Simons as a primary admiration for his intellectual curiosity, philanthropy, and ability to leverage mathematical advantage in investing.
• Personal Motivation: Brittain draws inspiration from his grandparents' emphasis on hard work and global exploration, and he currently manages a torn Achilles tendon, limiting his active sports participation despite a lifelong love of tennis.