Aschenbrenner’s AI Fund Collapse Is Just The Beginning

0:00Support for this show comes from Odoo. Running a business is hard enough, so why make it harder with a dozen different apps that don't talk to each other? Introducing Odoo. It's the only business software you'll ever need. It's an all-in-one, fully integrated platform that makes your work easier. CRM, accounting, inventory, e-commerce, and more. And the best part? Odoo replaces multiple expensive platforms for a fraction of the cost. That's why over thousands of businesses have made the switch. So why not you? Try Odoo for free at odoo.com. That's O-D-O-O dot com.

0:42Excuses are easy. An epic movie night? We don't have enough snacks. Dinner party with the girls? We'd have to decorate. Surprise date night? Nothing to wear. But Amazon's Prime same-day delivery lets you say yes before the moment slips away. Try that new popcorn maker. Order those cheeky drink glasses. Get that new perfume. And turn that I wish we could into an I'm so glad we did. Visit Amazon.com slash Prime to find millions of items delivered fast. Same-day delivery. It's on Prime. Available in select areas. Terms apply. Are you a pet owner? Every six seconds, a pet owner in the U.S. gets hit with a vet bill over$1 ,000.

1:27Always an unwelcome surprise. That's where Fetch comes in. Fetch is the most complete pet insurance for dogs and cats, according to consumeradvocate.org. You get paid back up to 90 % of vet bills at any vet in the U.S. and Canada, with claims paid back in as little as two days. Go to FetchPet.com slash save right now for your free quote. That's FetchPet.com slash save.

2:03If money is evil, then that building is hell.

2:12Welcome to Prof G Markets. I'm Ed Elson. It is August 4th. Let's check in on yesterday's market vitals. The major indices climbed after President Trump called off an attack and Iran indicated Hormuz negotiations are making progress. The Dow closed at a record high and Amazon reached a$3 trillion valuation for the first time. Meanwhile, Brent crude fell. The yield on 10-year treasuries declined. And finally, the Japanese yen climbed after the US joined Tokyo to support it. More on that later. Okay, what else is happening? For months, investors have been asking how the AI boom might end, and last week, they got a glimpse.

2:5724-year-old Leopold Aschenbrenner's fund, Situational Awareness, sent a letter to investors on July 24th, reporting a 439 % net return for the first half of the year. In a postscript, Aschenbrenner wrote that it was, quote, a particularly good time to add funds. But just six days later, the fund had lost roughly$35 billion in assets, plunging from a peak of$45 billion to around$10 billion. And Ashton Brennan was forced to unwind his entire public stock portfolio in a fire sale that ended up going to Ken Griffin's Citadel. Investors are reading this story as a warning sign for the increasingly debt-fueled AI boom.

3:42Situational Awareness reportedly used as much as 400 % leverage to amplify its bets on AI infrastructure. That helped the firm return more than 1 ,000 % since its inception. But when those bets went south, the same leverage accelerated the losses and forced the fund into liquidation. We wanted to talk to someone who manages the fund and who has spent years thinking about leverage and market structure. So we're going to discuss this with Michael Green, chief strategist and portfolio manager for Simplify Asset Management and author of the Yes, I Give a Fig Substack. Michael, thank you so much for joining us.

4:18Let's just start with your initial reactions to the implosion of situational awareness. How did this happen? What can we learn from it? You know, the quick answer is that when you look at somebody who is engaged in the behaviors that Leo has, there's really no mechanism for him to have learned not to do this. And so he had a very strong thesis. He expressed it with the extraordinary use of leverage. His initial exposure was largely to non-public entities, and he had grown his business under that framework, which has a component of much lower volatility framing to it because non-public entities don't reprice themselves in the same manner.

4:56But when you start running strategies that are running that much leverage against this much volatility for the individual securities, unfortunately, a blowup becomes inevitable. And it really looks like what happened within Leo's portfolio is that he created conditions under which a small decline in prices would force him to sell to reduce his leverage, which in turn caused prices to fall further, which caused him to be forced to sell to reduce leverage further. And ultimately that cascaded into an event that sent both his longs and his shorts against him. In particular, he very much had the thesis that traditional software companies would be heavily disintermediated by the growth of AI, in particular the software sector, that obviously contributed to the underperformance of that sector for a period.

5:46His selling actually contributed to the underperformance of that sector. And as he began to be forced to unwind his portfolio, that forced prices to move in the opposite direction of his underlying positioning and created conditions for the rapid collapse of the fund and the need to deliver it in as quick a time as he did. Nobody in their right mind should give a 25-year-old$20 billion at 4x leverage, but you actually can't blame the 24-year-old, right? The reality is he had a very strong view. He had a very strong conviction on his view, and everything in his experience based up to that point had told him that this was the right strategy to pursue.

6:27Once you become that large, the street actually identifies you as a target. You effectively become a wounded shark and a feeding frenzy emerges. You recently wrote a piece about how, I mean, many of the stocks that he was invested in, the semi-stocks like Nebius, Sandisk, Micron, etc., how a lot of the activity and the volatility that we're seeing in that market has been the result of the rise of leveraged ETFs. Could you talk more about how that is impacting the semiconductor sector right now and why it matters to investors? A levered ETF carries the same characteristics as Leo's portfolio, which is obviously running at 4x leverage.

7:10And the difference between the two is that a levered ETF, because it has a prospectus that requires it to maintain that levered exposure, has to rebalance every day. And this is where volatility creates a phenomenon called volatility drag. If you imagine a series in which I make 10 % today and lose 10 % tomorrow, many people would assume that the answer to that is I now have a zero return. But the reality is I start with$1, I now have$1.10, and I lose 10%. I have 0.99, 99 cents, I've lost a penny. If I add four times leverage to that, you actually end up with a two to the fourth power impact on that volatility drag.

7:54Instead of investing$1, I've now invested$1 of equity and$3 of borrowing. I'm up 10%. Therefore, I suddenly have 440, meaning my equity has risen because I only owe$300. My equity has risen to 140. That is a 40 % gain on a 10 % change in the underlier, exactly as you would anticipate. But if you do the exact same math for what happens now if I fall 10%, the compounding effect of that leverage and the need to rebalance it creates the conditions that cause these sorts of catastrophic losses. If you then add the additional layers you do with the ETFs that they need to rebalance every single day, it's not like they went from 140 equity with 300 of borrowing.

8:42they actually have to lever up that 140 forex. So four times 140 is going to be, you know, 660, right? So that actually means you were at 440 in terms of your exposure the day before. Now I have to increase my position sizes by nearly 50 % to maintain the leverage that I've promised my investors. That means that it creates what's called endogenous flow. It actually forces buying even without new investors adding money into the system. And it contributes to the sort of run-up that we have seen unless investors harvest those gains. So the piece that I wrote about is called A Semi-Theory of Everything.

9:23In explaining how this phenomenon plays out, when you have large series of complexes that have historically run on this, most professional investors would run them the way I described, as a volatility harvesting strategy, taking advantage of the fact that that compounding creates a loss, you actually short both sides of the trade and harvest the volatility loss associated with the volatility drag. It creates a very stable return profile as long as your volatility characteristics are maintained. Unfortunately, in the excitement of the post-March recovery in markets, early April to be more precise, We actually saw retail investors step into these types of products because they were seeking out a Leopold-like experience.

10:10They were actually buying these 3x levered ETFs or 2x levered single stock ETFs and then holding rather than harvesting their positions. We actually saw a behavior that suggested people were trying to dollar cost average into these strategies. If you run through the math on this, it is just a terrible way to invest. that 3x leverage running the level of volatility we were experiencing in the semiconductor space as of April, May, you would need a return in excess of 170 % a year in order to simply break even on the volatility harvesting. To dollar cost average into something that has 170 % break even is absolutely absurd.

10:53But again, a byproduct of the lack of education and candidly, the tools that we have put out into the marketplace with an objective to attract people to shiny objects as compared to thoughtful investment vehicles. It seems like South Korea is the perfect example of how this all goes wrong. I mean, we saw what happened last week. We saw the KOSPI, the South Korean stock market, crashing 44 % from its June highs. We saw literally more than a million people in South Korea receiving margin calls, hundreds of thousands seeing their accounts liquidated to zero. And we also saw a lot of protest from South Korea after this event.

11:37And a lot of people are saying, let's abolish these levied ETFs. Let's get rid of them. How could you let this happen to us? How could you allow us to become addicted to this stuff? Is that the answer? What do we do about these levied ETFs if they are such a dangerous investment strategy? Well, again, it depends on how you use them, right? So a hammer is a very dangerous tool if used improperly. It is a very productive tool if used properly. As volatility harvesting regimes and volatility harvesting tools, these can be used by professional investors to effectively short a realized volatility framework and create conditions under which profits can be generated by providing effectively the financing for those vehicles.

12:24um south korea has already banned the levered etfs they've now been forced to close their market multiple times over the past several weeks after and literally doubling the number of times it had been closed in a three-week period over its entire history since roughly 1990 they've recognized that these products have bear you know create almost no social utility in the united states we are still trapped by market fundamentalism and we see that in everything from Kevin Warsh's recent testimony at the Fed to the general view on regulatory frameworks within the United States, just let the market decide.

13:03There's a very real reason we don't do that. There's a reason we now have labeling on drugs that tell us what the addictive contents of them are. We now have labeling on food that tells us what the ingredient list is. And the reason why is because we used to have the same general view. Buyer beware. All right. You need to be responsible for yourself. Well, that's extremely difficult for an illiterate immigrant to figure out if the sausage that they are eating is filled with potato flour or if it is filled with meat. We recognize that. We took steps to address it. And in many ways, I think we often go too far in this.

13:40We do need to recognize that there is a role for experimentation and the utility of tools, as I was describing. We could ban hammers because somebody hurt somebody with a hammer. That would be a mistake, I think, under most economic framings. But in this case, we have created effectively a gambling environment in which people are increasingly nihilistic in their interpretation of prices, effectively assuming in many ways that governments are stepping in to support these prices or simply print money to create wealth to paper over the many problems that we see in our society. You and I have discussed some of those.

14:16That's simply untrue. I just would emphasize for the younger audience, never substitute conspiracy when incompetence will suffice. We have regulators who have largely abandoned their role. And as a result, we are left with a series of products that are being created that I would describe as half-boiled spaghetti being thrown at the wall in an attempt to see what sticks and attracts investor dollars. Just looking at what's happening in the U.S. now, assets under management in U.S. leveraged ETFs have reached a record$218 billion, up 60 % since the end of March. I mean, it continues to explode. All the things that went wrong in South Korea, they're becoming more and more popular in the United States.

15:01Are we headed for a South Korea-like implosion in the United States? Well, unfortunately, as you know, this is one of the key concerns, and it's tied to my work around market structure, the growth of passive and price insensitive. And in this case, we're referring to leverage vehicles that actually do not consider is what they're buying with leverage a good thing or a bad thing. They're simply fulfilling an investment mandate, what I call a systematic portfolio rebalancing. Those create conditions under which these types of feedback loops can play out. And I would highlight to South Korea that actually much of the problem was not generated in South Korea.

15:40We imposed these conditions in South Korea through the introduction of an unlevered memory-centric ETF, DRAM, in the United States, which exploded in size to almost as large as Leo Aschenbrunner's portfolio and was sending roughly half of its dollars in Korean won hedged terms. So they were selling the currency, buying the stock in Korea. It brings to mind the 1971 experience from U.S. Treasury Undersecretary John Connolly saying to the emerging markets, it's our currency, but your problem. This was our ETF and their problem. And I think, unfortunately, you're going to see the regulatory environment begin to recognize that, and it very well may be forced to change.

16:25Michael Green is Chief Strategist and Portfolio Manager for Simplify Asset Management. He's also the author of the Yes, I Give a Fig Substack. Michael, we always appreciate it. Thank you so much. My pleasure. After the break, why the U.S. is stepping in to support Japan. And by the way, if you're listening to this episode Tuesday morning, then sign up for our Substack live stream today at 11 a.m. Eastern with Aswath Damodaran. head to profgmedia.com to become a Prof G Plus subscriber now.

17:23the student loans you already have, SoFi offers lending solutions that are designed to help you move forward with confidence. If you're paying for school, SoFi private student loans can help cover up to 100 % of your school certified costs, including tuition, books, housing, and more. You can check your rate online in minutes and there's no fees required, including origination or late fees. And if you already have student loans, refinancing with SoFi could save you thousands in interest, reduce your monthly payment and help you pay down your loans sooner. You can also consolidate multiple loans into one simple monthly payment, and checking your rate just takes a few minutes online.

17:56Head to sofi.com slash profgstudent to explore your options and get started today. SoFi student loans are originated by SoFi Bank N.A. Member FDIC. Additional terms and conditions apply. NML S 696891. Please borrow responsibly.

18:17Support for the show comes from BCX, the public ticker for private tech. For generations, American companies have moved the world forward through their ingenuity and determination. And for generations, everyday Americans could be a part of that journey through perhaps the greatest innovation of all, the U.S. stock market. It didn't matter whether you were a factory worker in Detroit or a farmer in Omaha. Anyone could own a piece of the great American companies. But now that's changed. Today, our most innovative companies are staying private rather than going public. The result is that everyday Americans are excluded from investing and getting left further behind while a select few reap all the benefits.

19:18Until now. at bcx.com. This is a paid sponsorship.

19:26Support for this show comes from Odoo. Running a business is hard enough, so why make it harder with a dozen different apps that don't talk to each other? Introducing Odoo. It's the only business software you'll ever need. It's an all-in-one, fully integrated platform that makes your work easier. CRM, accounting, inventory, e-commerce, and more. And the best part? Odoo replaces multiple expensive platforms for a fraction of the cost. That's why over thousands of businesses have made the switch. So why not you? Try Odoo for free at odoo.com. That's O-D-O-O dot com.

20:10We're back with Prof G Markets. Japan's currency is collapsing. And last week, the United States stepped in to help. On Thursday, the Japanese yen fell to nearly 164 per dollar, its weakest level in 40 years. And that night, Tokyo intervened, selling as much as 59 billion US dollars to buy back its own currency. But then on Friday, the U.S. Treasury did something it hasn't done since 2011. It joined the intervention. Japan confirmed the operation yesterday morning. Trump framed it partly as a favor, calling it a, quote, signal of friendship. Here is what he said. We're very strong, very, very strong financially.

20:52They are, you know, they have a weakening yen and they wanted a little bit of help. And we're always there for Japan. And Japan's been very good to us, with the exception, of course, of Pearl Harbor. Joining us to discuss America's intervention in Japan, we're speaking with Katie Martin, markets columnist and editorial board member at the Financial Times. Katie, thank you for joining us on the show. I just got to start with your reactions to Trump's explanation as to why we have intervened here. Why have we done this? The line about Pearl Harbor is one of the unintentionally most hilarious things I've had in global macro for quite some time.

21:32But there's various different ways of looking at this situation. There is definitely an interpretation here that it's just nice to be nice. Right. And Japan has got a problem with a sliding currency and it's been trying to tackle it and it hasn't really been working. The currency's just sort of been, you know, gradually dripping lower this whole time. Nothing's really been working. Admittedly, Japan hasn't really tried really jacking up interest rates, but it wanted some help and the US came to help. And I think this is one quite important thing to bear in mind here is that one of the things that this joint intervention does, and as you mentioned, this is the first time the US has been involved at all in this kind of way since 2011, but that was a G7 intervention.

22:16Actually, as a bilateral thing, you have to go back even further. You have to go back best part of 30 years to find anything similar to this. Anyway, what it does is it's a signal to the world of we help our offerings. So if you recall, back end of last year, Javier Mille, the president of Argentina, he wanted some help with his currency in the run up to an election and Scott Besant came to help. some countries in the Gulf, in the Middle East, they needed some help around the time of the start of the war in Iran. And there was talk of opening up SWAT lines for countries that are friendly to US interests that might need them.

22:55So the US does make a show of being good friends to its friends. But I think there is more than a little self-interest going on here. You'll be shocked to hear. You know, Japan has two main ways of supporting its currency. It can raise interest rates really quickly, which is quite difficult to do for domestic reasons. Or it can sell loads of dollars. And I mean loads of dollars. And when it sells dollars, that means that it sells US treasuries. Now, I'm sure listeners to your podcast are well aware that the US treasury market is in a bit of a fix at the moment. Prices have been falling quite hard.

23:37Yields have been pushing up and borrowing costs have got really quite elevated, especially for long term debt. And so the last thing the US wants is for Japan to dump a load of new treasuries onto the market. So I think that's why they're getting involved here. It's kind of a case of standing behind Japan being that kind of big brother and saying to the market, back off, stop selling this currency. From my understanding, Japan has been selling treasuries all year. They've done it multiple times before this summer. And if the yen continues to weaken, I mean, it seems as if Japan will just have to keep selling more of its treasuries, or I guess the US will have to continue to intervene and continue to send money over to them.

24:28I mean, why wouldn't this keep happening? Why wouldn't this repeat over and over again? Well, that's the thing. You know, I've been talking to a bunch of people in the markets about what's happened over the course of today. And most of them are saying this stops the rot, you know, if there are speculative accounts out there that are trying to really harm the yen. And it's not clear to me that they are. It's not clear to me there's a massive market dislocation going on here. But in any case, this does help to slow that down. but really what would help Japan and what would help the currency to perk up at this point would be first of all some big rises in US in Japanese interest rates as I mentioned the problem there is again Japanese government bond yields they're pretty low by global standards but they're very high by Japanese standards and if they get much higher because Japan raises interest rates then all of a sudden there's a lot of Japanese investors for whom actually putting money to work in the US putting money to work in US treasuries kind of isn't worth it anymore.

25:32You may as well just keep that money at home. So again, a solution to the yen problem would potentially sap quite a lot of demand for US treasuries out of the system. And again, that's not really in the US interest. So what would really help the yen would be big rises in Japanese interest rates and or big declines in US government bond yields because those markets tend to be closely correlated. Now, the reason that US government bond markets are in trouble and the US borrowing costs are higher is nothing to do with Japan is because the markets are listening to what they hear from Kevin Walsh, new chair of the Fed, and saying, I don't get it.

26:19I don't understand how the how the Fed is is is relating to markets at the moment I don't understand why they're not raising interest rates given their stated objectives in addition to which the the Fed under Kevin Walsh is talking about talking a lot less to markets and that introduces volatility so ironically if if there was a shift in regime on the U.S. side that would actually do a lot more good for the currency on the Japanese side. So look, you know, will this go on all summer? Will we end up with the US constantly coming into the dollar yen market or weirdly the euro yen market? But will it have to keep on buying yen to try and support the currency?

27:03Or is just the fact that they're there standing shoulder to shoulder with Japan, is that enough to put the market off? and there's a good chance that it is. One of the strange things about this, Katie, is that actually the US is selling euros in this transaction, this intervention. Why is that happening? This is a total curveball. I have never heard of any country intervening in anyone else's market using a third-party currency before. This is a new one on me, a new one to everyone I've spoken to about it. But basically, it's a function of the fact that the pot of money that the US has stored away for these sorts of instances is predominantly in euros and yen.