Nuclear physicists, unreported exits, and huge losses: How an $80 million hedge fund blew up in one month

On September 11, Spruce Alpha, a small hedge fund that is part of a bigger investment group, sent a short report to investors.

The letter said that the $80 million fund had lost 48% in a month, according the performance report seen by Business Insider.

There was no commentary included in the note. No explanation. Just cold hard numbers.

Around the same time, the fund's founder, John C. Bailey, made phone calls to the fund's investors to walk them through what happened in August, according to one person familiar with the matter. The thought was that a call was better than a letter, one person said.?

The small, Stamford, Connecticut-based fund had blown up after a horrible August.

The fund will return the remaining capital to investors, according to people familiar with the matter.

Spruce Alpha wasn't the only fund to get tagged during that period. The average hedge fund was down 2.2% in August, according to data from Hedge Fund Research. Meanwhile, the S&P 500, fell 6.2%.

With those losses, though, Spruce Alpha places among the worst performers for the month of August. To put it in perspective, the worst performer that Barron's included on its list for the month of August fell 36.1%.

This is the story of how a small fund closed a little over a year after launching.

The demise of the fund highlights a number of key risks in the hedge fund industry. Trading strategies can prove profitable - Spruce Alpha finished 2014 up 21.6% and was up 1.7% heading into August - right up until they prove disastrous. Key executives can leave, sometimes with little disclosure. And in the end, investors can get wiped out.

Too much volatility

REUTERS/Pawel Kopczysnki

Screens were flashing red in August.

Spruce Alpha is part of $1.8 billion fund manager Spruce Investment Advisors, which was founded by John Bailey in 2001. Arizona-based private-equity firm Estancia Capital Partners owns more than 25% of the firm.

Estancia did not return calls seeking comment.

Bailey began his career in equity research at Oppenheimer & Co. and later worked in equity asset management at Columbus Circle Investors, part of PIMCO. He was also the CEO of a private family office.

In April 2014, Spruce Investment Advisors launched Spruce Alpha Master and its two feeder funds - Spruce Alpha Fund & Spruce Alpha Fund Offshore. Collectively, the funds managed around $80 million in assets, according to documents seen by Business Insider.

The hedge fund made up 4% of the total firm's assets, and was set up to benefit from volatility, according to the fund's documents.

"The Spruce Alpha Fund seeks to generate high alpha, low beta, and low correlation returns by identifying daily-resetting, highly-levered ETFs experiencing volatility decay, and shorting them in bull and bear pairs," the fund's performance reports state.

Undisclosed departures

Bailey ran the hedge fund, one person said. The fund's brochure said that he "maintains ultimate responsibility for the company's operations." Others disagree.

Robert Stock, a 48-year-old with a Ph.D. in physics from Carnegie Mellon University and a bachelor's in physics from Princeton, was also a key executive, according to one person familiar with the fund.

Stock had experience making quantitative models that the fund used, according to his profile. Before Spruce, Stock spent nine years as a researcher in the Directed Energy Group at MIT's Lincoln Laboratory, a defense-related lab, where he performed simulations of high-energy-laser systems for missile defense.

The brochure said Stock's "investment recommendations are supervised by Spruce's CEO, John C. Bailey and the Investment Committee."

Stock, who had been with Spruce since 2005, left the firm on April 15. Investors were not made aware of his departure until September, around the same time the losses were announced, according to one person.

Stock's bio remained on the website until that time.Stock did not comment beyond a prepared statement.

"The alpha fund was an actively managed strategy strategy that demanded the daily involvement and input of its managers. Having left in April, amid a number of other management departures, it is impossible for me to know how the strategy was implemented after I had left. The basis upon which the strategy was originally formulated is sound, and I wouldn't hesitate to put my own capital behind it," Stock said in the statement.

After Stock left, Bailey brought on Michael Robbins, a former chief risk officer at Utah Retirement Systems and, most recently, a former managing partner of ECR Capital Management. Robbins has a bachelor's in nuclear-engineering physics from Rensselaer Polytechnic Institute.

Gil Orbach's, the firm's chief investment officer, who was responsible for "helping formulate and implement the firm's asset allocation, risk management, and portfolio rebalancing," appears to have left the firm in May 2015, according to his LinkedIn profile.

Orbach's profile also remained on the website, according to screenshots seen by Business Insider. Orbach did not respond to a request for comment.

The explanation for the profiles remaining on the website until recently was that the firm was in the process of a complete overhaul of its webpage, a person said.

Crazy August

A few months after the departures of the executives - one of whom had experience in building the models the fund used and one of whom was responsible for risk management - the fund was hit by a perfect storm.

"These individuals had nothing to do with the performance of the Alpha Fund," Bailey said in a statement to Business Insider.

The strategy of shorting highly levered ETFs needs choppiness. It needs the market to go up for a few days and then down for a few days, according to one person familiar with the fund.

In August, the market just went down. Volatility spiked to extreme levels. Over the last week of the month, there was a so-called seven-sigma move in equities, an all-time record change in the volatility of volatility, and a 700-point change in the S&P 5oo.

Bailey told investors that the fund was hit by the largest five-day rise in volatility recorded since the advent of the volatility index (VIX) in 1992, according to the people familiar with the matter.

That combination proved disastrous for Spruce Alpha. The fund crashed, losing close to half its value in a matter of weeks. A trading strategy that had proven consistently profitable, with just two losing months prior to August 2015, was ruined.

"The losses were caused by unprecedented market events that led to similar strategies losing money - even more than Alpha in some cases. We are disappointed in the performance of Alpha, and we regret that some of our clients lost money and are upset. We are addressing their concerns directly and moving forward," Bailey's statement said.