A $3.4 billion hedge fund's letter raises a fundamental question about the future of the industry

• A $3.4 billion hedge fund, Tourbillon Capital, has been losing money in its flagship fund.
• "It highlights the challenges of remaining disciplined in a consensus and ETF driven persistent bull market," the fund's founder, Jason Karp, wrote to clients.
• The fund's latest client letter indirectly raises a fundamental question about the industry's future: What is the role of a hedge fund manager?
• Tourbillon still sees a future for active managers, and lesser known stocks could provide opportunities.

Tourbillon Capital, which manages $3.4 billion, has been losing money in its flagship fund as the bull market rages on.

The New York-based firm, which focuses on stocks and is run by Jason Karp, has written in quarters past about why the firm is struggling. The firm's most recent client letter, for the second quarter of this year, was reviewed by Business Insider, and the themes are much the same.

In particular, it states that quantitative and passive investing have changed the market. Quants use algorithms to make investment decisions, and often follow short term moves. Passive funds track market indexes. Both are challenging active managers, the human-backed stock pickers that have traditionally dominated Wall Street.

Reading between the lines, the letter raises a question about the future of the industry. Should hedge fund managers invest in stocks they don't believe in because passive and quant funds are likely to pile in? Or should they remain disciplined, even if that means losing money in the short term?

"We prefer the pain of discipline (adhering to our process and remaining low-net) over the pain of regret (chasing what's working and running all-time high exposures) but, alas, hindsight is 20/20, and the counterfactual of the other histories that could have happened never transpired," Karp said in the letter.

We've pulled out the most relevant excerpts.

'No one wants excuses'

"At a time when no one wants excuses, it would be far easier and more convenient if we could convey to you, our partners, that we had a breakdown in decision-making or a position or two that cost us disproportionately," Karp wrote.

The reality is more nuanced, according to Karp, who cited two interrelated causes. First, its longs and shorts have been on the "opposite side of this tectonic shift of capital from active to passive." In addition, the fund has been reducing its exposure to popular tech, media and telecommunications stocks that have been driving the market higher. Karp points out that many of the top performing funds this year have focused on tech.

"It is easy to understand why the broad TMT space is so desirable," he wrote. "Nearly 40% of the S&P's return this year can be attributed to a sector that represents only 20% of the index's capitalization. The penalty for not owning what is 'working' is meaningful for active managers, and passive strategies only exacerbate the problem."

By Tourbillon's estimate, the Goldman Sachs VIP index, which measures the most important stocks to hedge funds, about 80% weighted to TMT oriented names. By comparison, it was about 10% TMT weighted in 2015, and is now well above the S&P's 20% weighting to tech, Karp wrote.

Tourbillon's performance

Tourbillon's Long Alpha fund is up about 13% through July of this year, while its TGMF long-short fund is down about 2% over the same period, a person familiar with the numbers told Business Insider. By comparison, the S&P 500 delivered 10.4% over the same period. Last year, TGMF dropped -9.2%, according to investor documents previously reviewed by Business Insider, compared to a 9.5% gain in the S&P 500.

Karp points out other ways the rise of quants and passive investing have hurt his firm's strategy:

• "We saw that our largest longs have been underrepresented in passive strategies, due to lack of analyst coverage, lack of dividends or complex ownership structures, whereas our shorts have been well represented in passive, and just like being short companies with a meaningful buyback, we have seen marked effects on prices from these supply/demand imbalances."

• "Despite being right on fundamentals YTD, our top longs have gotten cheaper while our top shorts have become more expensive. This has been a difficult headwind to overcome, and our research (which we can show on-site to those interested) robustly supports the conclusion that this is primarily a function of our active/passive tilt in our largest positions."

How active management could win out

Karp said that there is scant data to show what happens to stocks on the "right side of this tidal wave of passive inflows" once the money stops flowing in. However, he said that large cap stocks that benefit from the most ETF inflows "see material underperformance in the following year compared to those that have been hurt from outflows."

"This suggests, for patient investors, that mean reversion still applies on a broader scale," he added.

Karp also believes that as money pours in to the hottest stocks, lesser known stocks provide opportunities. He picked out two stocks, Halcon Resources and NRG Energy, which both sold assets and then saw their stock prices appreciate rapidly. From the letter:

"If the public markets (or whatever blind, passive allocators and machines) cause the stock prices to diverge considerably enough from their true value, we would expect to see many more situations like Halcon and NRG. This rise of passive unequivocally creates opportunity for those who do deep work and understand these businesses better than what the stock prices suggest."