Inside a Young Hedge Fund’s Dramatic Breakout Year

Surrounded by losers, Castle Ridge rides AI to 20+ percent returns.

Castle Ridge offices in Toronto, Canada. (Stephanie Foden/Bloomberg)

Castle Ridge offices in Toronto, Canada.

(Stephanie Foden/Bloomberg)

With market neutral funds bleeding value, one hedge fund stands out — with the help of artificial intelligence.

In its first year, hedge fund Castle Ridge’s equity-market neutral strategy returned 20.4 percent, before fees, over the twelve months ending in September. Year-to-date, the strategy generated 16.1 percent gross and 12.5 percent after fees, according to a client letter obtained by Institutional Investor.

The fund beat the index by a whopping 23 percentage points this year. From January to September, the HFRX Equity Market Neutral Index lost 6.6 percent, while Standard & Poor’s 500 stock index was up 4.1 percent.

The S&P 500 and market-neutral benchmark lost ground in September (3.8 percent and .8 percent, respectively). But Castle Ridge, powered by an AI platform called Wallace, was up 1.5 percent before fees. The market-neutral strategy invests in liquid U.S. equities.

Castle Ridge doesn’t use machine learning approaches like neural networks and deep learning. Instead, the firm claims an AI technique called “geno-synthetic algorithms,” which adapts and evolves to changing market conditions.

CEO Adrian de Valois-Franklin made technology venture investments for Accel-KKR, and worked at the Canada Pension Plan Investment Board, before co-founding Castle Ridge.

Castle Ridge tested its Wallace AI platform with proprietary capital between 2013 and 2016, applying it to volatility arbitrage, fixed income, currencies, and global equities.

AI is among the hottest areas in investing, but many asset managers remain reticent or uninformed about adopting the techniques to make investment decisions. In part, that’s because the rules change in financial markets and the decisions made by AI-powered systems can’t always be explained to investors.

But for certain funds with the acumen, AI is an edge.

“Castle Ridge not only outperformed, but did so with a fraction of the volatility while the market was crashing around it,” according to the client letter. “In possibly the toughest stress test through the height of the February/March pandemic, Market Neutral posted a 5.2 percent gain over this period while the SPX plummeted over 20 percent.”

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In the letter, the firm’s principals gave a behind-the-scenes look at the strategy and how it survived when other quant funds were hit hard.

In the fourth quarter of 2019, the market-neutral fund’s first three months of operation, Castle Ridge generated 3.7 percent gross returns. But the firm said markets at that point were quite placid.

“By the end of February, VIX broke 30 and the first signs of trouble hit the markets like a runaway train,” wrote the firm’s principals in the letter. While the S&P 500 fell 19.6 percent in the first quarter, the market neutral strategy was up 4.6 percent on a gross basis. “These were the ultimate stress test conditions, allowing Wallace to show true market immunity with low volatility of returns,” according to the letter.

In the second quarter, the fund got defensive. During the two months of April and May, the fund went to cash several times. Still, the market-neutral strategy returned 7.8 percent for the quarter.

Castle Ridge explained that in the next three months, Wallace went on the offense. The fund bought shares in pharmaceutical firm Moderna before the company announced its progress with a Covid-19 vaccine. “By far, the biggest success came from Wallace’s top position in Immunomedics (IMMU) before Gilead announced a $21 billion acquisition leading to a 108 percent stock price surge. These savvy plays helped Wallace post a 4 percent gross profit in Q3 despite the rapid sector rotation playing out during August and September,” said Castle Ridge.