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Management in Practice

Can Hedge Funds Be YouTubed?

Keith McCullough YC ’99, founder and CEO of Research Edge, left the hedge fund industry in 2007 to try something different. He is assembling a team of research analysts who will bring the day-to-day informational edge of a hedge fund not just to institutional or extremely wealthy clients but to retail investors as well. But is the idea of an open hedge fund an oxymoron?

Research Edge provides clients with information and recommendations through their Hedgeye service but won’t manage money or carry out trades. McCullough believes that by turning the model of hedge funds and investment banking on its head he can do for investing what YouTube did for broadcasting — make everyone, including his own firm, accountable.

Q: What is Research Edge?
Research Edge is run like a virtual, buy-side hedge fund. When you look inside, you see exactly what you would in a hedge fund network that's on the big boards. From the moment they arrive until the 8:30 morning meeting, everybody is working towards having an incremental edge to contribute. After that, we are working our contacts and banging it out all day long, communicating on the research platform.

Someone like Jim Cramer really opened the world's eyes to "Hey, I like this" or "I don't like this" and showed that people would actually act on those recommendations. But he never told the next part of the story; he wasn't accountable to the position.

My track record, since I left Carlyle at the end of October of 2007, is online. With our new software platform, it is now displayed in real-time. Everyone can look at it daily. We're the only ones in the marketplace doing that, as far as I know, and we have a user-experience that is more Apple-esque than anyone else, so it will be incredibly easy to use and follow.

Furthermore, Research Edge has three principles: transparency, speed, and accuracy. Three things you don't think of when you think of Wall Street. But our communication of the research is crystal clear. It's transparent, accountable to the minute and to the penny.

Q: Who are Research Edge’s subscribers?
We started on July 1st and we have about 150 institutional clients ranging from hedge funds to mutual funds and everything in-between. They pay premium prices for different levels of granularity on the research or to have access with one of our sector heads on the phone. The institutional community is watching us, but they don't really have to because we don't have sales and trading or asset management, so there is no reason for them to pay us, other than our research which is the way that that should be; it is completely free of conflicts and we have a process that we follow based on models refined over time.

The research team is already cash-flow positive, self-funding. That's the beauty of my model. We pay sector heads 50% of what they bring in and the rest goes to the firm so we can develop talent, and have good coffee instead of bad coffee, and so we can develop Hedgeye. That is a good hedge fund's economics. But it's only been for the portfolio manager until now. I asked why it couldn’t be there for a research analyst.

Q: What is Hedgeye?
Hedgeye is a mass-market delivery of our research. There are 95 million investors in this country. The average Hedgeye subscriber will pay approximately $75 a month. We don't have ratings, just green eyes and red eyes; meaning long positions (green) and short positions (red). We took out all the nonsense like "super-strong buy" or "medium hold" that “Investment Banking Inc.” has. And the reds or greens are attached to one of four types of transactions: buying, selling, shorting, or covering.

People see my record for the last year and ask, "Why aren't you managing a hedge fund?" And the answer is quite simple: I’ve done that. This is far more exciting to me. Democratizing the process by which research is communicated, that's the big thing. That's what nobody has done. That's what YouTube has done to broadcasting. That's what Google has done to advertising. That's what eBay has done to any kind of buy-sell transaction. Nobody has done it in finance and rather than talk about transparency and accountability the way Wall Street does, we’re just doing it, in the most open and honest way possible. People can just as easily track positions we’ve done incredibly well on, as they can positions that we’ve lost money on. There is absolutely no smoke and mirrors.

We're going to dis-intermediate the broker and empower the consumer. We’re going to give the investor the information that the research department gives an analyst and we’re going to be more accurate and timelier.

Q: You worked in hedge funds before this?
Since 2000. The best call I ever made was leaving the industry in 2007. It was lucky, but you could feel it. The market felt toppy and so did the hedge fund industry.

I was a partner, portfolio manager and managing director at The Carlyle Group’s hedge fund, Carlyle Blue Wave. Before that I worked for Dawson and Herman Capital Management from 2000 to 2005.

In 2005, I was able to launch my own fund, called Falconhendge Partners. In the first quarter of 2006 we had a 6% net return. And that's the only number that I'm allowed to put in print, because it was mine. The largest book I managed, as a magnitude of capital, was $400 million.

Magnetar Capital, which is run by ex-Citadel star Alec Litowitz, acquired my team at Falconhenge and folded my hedge fund into theirs in mid-2006. I moved over to Carlyle in 2007, and sat on their hedge fund’s investment committee for the long/short equity side of the business. We launched that fund in April 2007, and I was gone by the end of October. The fund closed down 9 months after that. My last day on Wall Street was very near the market top.

Q: Why did you leave?
Investment Banking Inc. is conflicted, constrained, and compromised. For the last five years, everyone got paid so much that it really masked a lot of structural issues that were starting to build in the industry.

We have just evaporated three of the five major investment banks, and the other two are bank holding companies. The three key aspects of an investment bank — asset management; investment banking; and sales, trading, and brokerage — all have to have research to run. All of them will tell you, even today, you can't monetize research. I don’t think it’s true. Research drives the business and is the nucleus of all good decision making.

The whole way people have been telling me that I'm nuts. But investment banks can't do what they purport to do, so those who support the analytics are going to be there to help capital meet the assets. Investment Banking Inc. can't communicate real-time because they have to give you a litany of disclosures. If they have banking relationships, they've got to disclose that. If they trade, they've got to disclose that.

If a company is saying something on a conference call, while they're talking we can be writing to our clients. That's the change. We're doing exactly what the buy side does on instant messenger with each other, however they continue to do it in a very disorganized way.

Q: How are Hedgeye and Research Edge different from a stock picker or any other research firm?
We are transparent. We are accountable. We are real-time. People can follow our process and thinking in a very organized manner. We’re also democratizing research and its pricing, but also giving everyone (from institutional investors to retail investors) a user-experience they will not only enjoy, but trust.

Look at the history of innovation in this country. Andrew Carnegie used technology to cut steel prices by 90% and give Americans and the world a better product. We’ve seen this with industry after industry. And finance? They raised prices. So you have an industry that pays themselves higher fees every year and has not been forced to cut prices and deliver better technological expression of the product.

This is one of those big, big ideas to create the new Google or Facebook. I would assume that I would be expected to fail at this point. But I'll take that bet all day long, because the people I have at Research Edge are the best at what they do, you're betting against all of them, too.

We have our own contacts. And we know these assets better. We don't have banking. We don't have asset management. And we don't have sales, trading, and brokerage. It actually sounds very populist, but this is not political. This is just right.

People born after 1981, want to be self-directed investors. They want to be part of the process. They want to act. They want to do something. It's not unlike American Idol or Fantasy Football. It's not unlike what ESPN did in 1981 in Bristol, Connecticut — they put professional athletes on to give the commentary. They believed that people will care more about what the pros say than what everybody else who is trying to comment on sports says.

Q: Say Hedgeye gets to the mass scale of YouTube or American Idol, where there is a huge number of people using it. Won't the first ones acting on this information get the advantage and subscribers acting 10 minutes later will lose out?
That would be a high-level problem to have. We issue trends and trades. A trade is an immediate action — we call it three weeks or less — whereas a trend is something three months or more. When we issue a trend, we believe it's going to be something that's more than a day trade. It would be a Herculean achievement to say that everything that we said got immediately priced in on an efficient basis from the longer-term trend perspective, because that just doesn't occur.

Q: Many hedge funds made or lost a great deal of their money through the use of leverage. Is that something consumer investors should be using?
No, they shouldn't. This is actually one of the main reasons why I left Wall Street. I've never used leverage. It's a much more conservative way to invest. Yes, your returns are going, on average, to be lower. But your risk profile is also going to be a lot lower. So I don't know really why people use so much leverage, and I would never encourage the consumer to use it.