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MICHAEL BURRY PREFERS NOT TO DISCUSS THE FUND MANAGERS WHO HAVE invested with him. But when it comes to Chalkstream Capital Group and its CIO, Andrew Tsai, the California physicist-turned-hedge-fund-manager, who earned a fortune shorting the U.S. subprime market, makes an exception. “I found Andrew and his team to be highly intelligent, very engaged and very well informed as to their understanding of the space,” says Burry, who wasn’t always on the very best of terms with all his investors. Today, Burry manages only his own money.

Tsai needs to be exceptional. Chalkstream’s small client base consists almost entirely of hedge fund executives and partners at major banks and asset managers who have entrusted the New York–based firm with their personal capital. As some of the world’s top investors, they have high expectations — none more so than Tsai’s business partner, Peter Muller, a former proprietary trader at Morgan Stanley who left the bank last year and launched quantitative hedge fund firm PDT Partners.

Muller and Tsai founded Chalkstream in 2003 as a family office to run Muller’s money. From the start, though, they planned to attract like-minded capital and create a bespoke firm catering to sophisticated investors. The pair found clients who could stomach relatively high risk and volatility in exchange for the potential payoff from bold bets on unique opportunities. “We want to traffic in areas where there is not a lot of capital chasing for returns,” says Tsai in an interview at Chalkstream’s Midtown Manhattan offices in the Random House Tower, an address the firm shares with PDT.

Tsai and his 12-member team have caught some of the most interesting and profitable trades of the past decade. Despite Chalkstream’s impressive pedigree and investor base, however, its overall returns have yet to truly impress. But the firm is confident that it can hit a home run with its biggest bet yet: on Japan, the graveyard of many a brave fund. If   Tsai succeeds, Chalkstream will have lived up to its promise.

With $700 million in assets and a dozen significant outside clients, Chalkstream is a hybrid of family office and fund of hedge funds. When it isn’t developing its own investment ideas, it looks for one-of-a-kind managers like Burry and his former firm Scion Capital. Chalkstream’s fund-of-hedge-funds portfolio consists of 15 to 20 managers, and it keeps a second, less-liquid portfolio for major tactical — though not necessarily directional — bets and private-equity-type opportunities. The mix can vary, but the firm typically splits its assets about 60-40 between the two. Chalkstream charges an annual 1 percent management fee and 10 percent performance fee on the hedge fund portfolio, and a 15 percent private-equity-like performance fee for the illiquid portfolio.

The firm’s philosophy sets it apart from institutional investors and funds of  hedge funds that focus on asset allocation and avoid market timing. Chalkstream tries to stay out of step with stocks and bonds — its clients have enough exposure to both — and makes large calls that would spook more-traditional investors. “We think traditional asset allocation is very dangerous,”  Tsai says, “since people are allocating on the past, not the future. We are not in the business of filling buckets; we are in the business of finding opportunities.”

Besides shorting subprime mortgages in 2007, Chalkstream profited from 2009’s run-up in Brazilian commercial real estate and the 2010 subprime rally.  To really thrive, though, the firm must grow its assets. With that in mind, Tsai and Muller want to start attracting institutional capital. They’re keen to lure some big fish: corporate pension funds and other institutions that might see their shop as an idea generator as well as an investment opportunity.

But even a sophisticated hybrid firm like Chalkstream faces the same headwinds as other hedge fund advisory businesses. Many investors are unwilling to pay the double layer of fees, the cost of doing business and the barriers to entry are rising, and few managers are posting extraordinary returns. Investors may admire Chalkstream, but privately some admit to disappointment with its performance. Through the end of 2012, it had returned an annualized 5.6 percent net of fees since inception in 2003, compared with 50 basis points for the HFRI Fund of Funds Composite index, but Chalkstream was stung hard in 2008, when its hedge fund portfolio finished the year down 44 percent. (The firm declined to comment on performance.)

Although Chalkstream quickly bounced back, the 2008 stumble also raised questions about the team’s ability to time its best ideas given its relatively early exit from the subprime trade. These are questions that the firm hopes to silence with the new Japan investment.

That trade has an equity and a credit component. Known for its deep-dive investment process, the team has been researching the Japanese market for at least six years, led by partner and investment analyst Rishi Shah, who has visited the Land of the Rising Sun alone and with Tsai. In Tsai’s view the current Japanese economy shares some structural similarities with the U.S. subprime market before 2007. As proof of its conviction, Chalkstream is raising its first-ever stand-alone fund for the investment.

“I look at what they are doing in Japan right now, and I really like their thesis,” says longtime Chalkstream investor Arjun Divecha, chairman and head of emerging markets at $106 billion, Boston-based money manager GMO (formerly Grantham, Mayo, Van Otterloo & Co.). “What is exciting to me is the way they are going about it.” For more than two decades, Japan has proved a terrible place to invest, Divecha notes, but Tsai and company “have found a can opener to open the can that has real potential,” he says.

Tsai, 41, was born in St. Louis; his family had moved there from Taiwan so his father could earn a Ph.D. in engineering. The younger Tsai graduated from the Wharton School of the University of Pennsylvania in 1993 with a BS in economics; he wrote his senior thesis on how to set up a hedge fund.

After interning with broker-dealer Susquehanna International Group, working as an open-outcry trader on the floor of the Chicago Mercantile Exchange, Tsai joined Lehman Brothers Holdings’ fixed-income trading desk in New York. In 1997 he left Lehman to become CIO of   New  York–based Integrity Capital Management, a quantitative hedge fund he launched with four other partners, including two former Goldman Sachs Asset Management executives. At Integrity, Tsai got to know Chalkstream co-founder Muller, an investor in the fund. “I was just really impressed by how he thought, how he conducted business, his character and his passion,” says Muller, whose PDT Partners manages more than $2 billion in assets.

Integrity closed its doors in 1999, a victim of the crash that brought down its much larger rival Long-Term Capital Management. Tsai joined the tech boom, becoming president of    Urbanfetch, a start-up with offices in New York and London that let customers order whatever they wanted online and receive it by messenger. By 2003, Urbanfetch, like many other dot-coms, had folded. Tsai was working in London as CEO and director of Global Name Registry, an Internet infrastructure company backed by U.S. private equity firm Carlyle Group, when Muller came knocking.

Now 49, Muller grew up in Philadelphia and New Jersey and majored in math at Princeton University. After college he moved to the San Francisco Bay Area and took a job as a researcher and programmer at pioneering quantitative research firm Barra. In 1992 he moved to Morgan Stanley, where he built up its famed proprietary quantitative trading business, PDT — although the bank never broke out returns, this unit was known to be highly profitable — and quickly established a reputation in the close-knit quant community.

“I think the first time I ever spoke to Pete, he called me up to yell at me,” says Clifford Asness, founding and managing principal of $70 billion, Greenwich, Connecticut–based quantitative alternative-investment firm AQR Capital Management. Muller had gotten wind that AQR might be interviewing someone from PDT, and he was not happy. The two quickly put the matter behind them and became friends, but Asness says Muller remains “quietly one of the most competitive guys you’ll ever meet.”

While at Morgan Stanley, Muller started investing his own money with hedge fund managers. “I realized that trying to pick good funds, keep track of   how they were doing and figure out how to allocate was just as challenging an investment business as running a hedge fund,” he says. “If  I was going to do it, I wanted to do it well, and I didn’t have time or inclination to run another business myself.”

Muller decided to launch a family office and put  Tsai in charge, but he knew he would have to be open to accepting other people’s money. “I didn’t have enough capital to afford Andrew and a world-class team,” says the skilled pianist and songwriter, who has performed at numerous venues in New  York City. “So the idea was that over time if we were successful and we liked doing it, we would bring in outside investors.”

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