Inside the Gerber Statistic with Sander Gerber of Hudson Bay Capital

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Strap yourself in for another good one. Sander Gerber, CEO CIO of Hudson Bay Capital. What a fascinating background he has, starting in philosophy and ending up on the floor of the American Stock Exchange as an equity options trader. That experience, those two things combined to really create a kind of unique perspective on the world of markets, on the world of risk, and on the world of models. You know, I've used the George Box quote a million times. All

Well, actually, I was good at math, so I first entered the Wharton School undergrad. I don't have an MBA from Wharton. And then when I was at Wharton, I didn't think I was getting an education, so I decided to transfer into the College of Arts and Sciences, so I got two degrees. Concurrently, I picked up a degree in philosophy. Humanistic philosophy. I wanted to understand the development of thought, how we got to where we are in.

Society, epistemology or something more specific.

It was moral philosophy, generally, starting with the ancient Greeks through the existentialists. I think that I used my philosophy background much more than my finance background, because it really gives you a different view on the world. When I was at Wharton colleg Andrew Krieger came in nineteen eighty seven to speak. He had majored in Sanskrit Eastern philosophy and then he got his MBA at Wharton and he

That I definitely can see that. You know the concept. I don't know if I'm stealing this from Zen Buddhism, but it's the water flows, but the rigid tree breaks in the storm, and it's very similar to, hey, that's an Eastern way of saying, why are you finding the trend exactly?

And so, you know, when I was in college, I really didn't know much about the markets. And as I told you, I still I had entered first the Wharton School, so I was still getting my degree there, but I was really focused on the philosophy. And you know, people think the philosophy is not so practical, what are you going to do with it? And here the top FX trader in the world came and said, this is what you should be doing. So it was it was sort of, you know, ratification of what I was studying.

Huh. I think you're the first person who I've ever spoken to who said, yeah, the Wharton School of Finance at University of Pennsylvania not a great education. Isn't it really true that most of our education, or at least for a lot of people, you're just self taught. Schools will give you a curriculum and here's the reading list, but it's up to you to kind of learn whatever there is to learn.

I think it's a good point. You know, the Wharton School is arguable the finest finance school, but finance is a technical discipline, and I wanted to understand the world. And I think that you can only go a certain degree using that background. And it's true. Then in order to I think, upgrade yourself, you've got to be able to develop the capacity to self learn, to take in from the environment around you, to enable yourself to grow your skill set to your experiences through working with others.

So you come out of of Wharton and University of Pennsylvania, you start your career on the floor of the American Stock Exchange as an equity options market maker. That had to be a fascinating experience, especially nineteen nineties and two thousands, that was a hot period and option trading. Tell us a little bit about that experience.

Well, actually, when I graduated Penn I had been I'd clerked on the floor of the Philadelphia Options Exchange in nineteen eighty seven, and I liked it. But my parents had spent all this money to send me to a fancy school. They had taken out a home equity loan to pay for my college tuition. So I thought to be a muslely floor trader would be disrespectful. So I went to Banning Company for two years, and I was

Wait before you jump to the AMEX. Aside from learning that being was boring, what else did you learn?

I learned how people can work together in good conscious with dedication and still muck things up. Because what we would do is we would parachute into places like British Airways, Montreal Trusts, uh CIA Industries, and we were like the external strategic planning and we would They would put young people like me, and we'd sit next to people and interview them and figure out why projects went to muck.

So what was it that drew you to the floor of the well?

I enjoyed the Philadelphia floor, and also I was I always liked games, and so I and I had a talent I thought for trading, and so I went to the the AMEX. Someone gave me it was like eleven hundred dollars a month as a stipend, and I kept roughly half the profits. And there was no training. They just threw me there very in the deep.

End of the pool. Whoever doesn't drown. Hey, you can grab.

Exactly right, exactly right. And it took me from July of ninety one till December of ninety one. I made five hundred dollars profit. Not for me, five hundred dollars. Trading had a split which I had to split. Yes, well, actually because I had a draw, I didn't get anything. But then the next year I took off and it turned out that I did have a knack fort I was able to understand the volatility of the market. Is usually we're vol traders, and I did something that was

Okay, all these things we kind of take for granted. I know, right at one point in time, you wonder why it's become so increasingly difficult to beat the broad index. It was a ton of inefficiencies, that's right, that's right.

And it was a great edge for me to come to that realization. And maybe it was because I had studied the models at the Wharton School. We had broken them down, and I understood that the models are only as good as the inputs. And a lot of people back then were doing spreads in their head and the other group were using these canned models that would give you one volatility exposure across you know, the entire model.

So these are really second or third level derivatives. It's not the underlying value. It's the increase in value of the option and then within that the range and the variability of that increase in option value. That's what you were trading.

Yes, and you know it's really not complicated. I mean Wall Street tries to make things much more more complicated than they are, but the simple, elegant solution is always better. So it might sound complicated, but it's really not right.

And that complexity is a feature, not a bug. You can sell stuff if it's complicated and hard to understand. If it's simple, well I think I could do that.

That's right. Wall Street tries to make things more complicated because it has to justify the sales commission and if but things really are not so complicated.

So what was your biggest takeaway from your experiences as a trader? How did it shape how you look at the world of investing, How did it affect what you're doing in Hudson Bay today.

Well, I really was grounded by that three and a half years of watching every tick on the stock. You know, and you're you're geographically limited on the floor. You can only trade at the post that you're standing by.

Like physically in space, your physically heether to that trading thing exactly.

And there are even rules that you had to do most of your trading in that geography, so you couldn't move around a lot. And what it taught me is that, you know, like a trading post, a strategy goes in and out of favor, and if you want to be able to make money in all markets all the time, you have to develop a toolkit that can go beyond one particular strategy. So you need to have multiple strategies

So I want to unpack what you just said, because it's filled with goodness. First, you're referring to your approach is Hey, we're really more process focused than outcome focused, because if you have a good process, even if you get a bad outcome, it doesn't matter. Probabilities will eventually work in your fay.

Exactly right.

That's number one. But then the part two, which I think a lot of investors overlook, is and a risk management component that if the worst case happens, we still survive and lift to trade another.

That's right, exactly right. And so at Hudson Bay, I created the deal code system, uh.

Deal code system.

Yes, so at the time, well, I left the floor beginning of ninety five and started deploying just the money I'd earned on the floor in an off floor trading account. And I would develop a strategy and hire someone else to run it and develop another strategy and hire someone else to run it. And as I was having other people manage basically my trading account, I realized I had to scale my risk profile that I developed on the floor over multiple risk takers, and I needed to do

So let's talk a little bit about Hudson Bay's strategy. You've been managing outside capital across a variety of asset classes and strategies. Tell us talk about some of the key strategies and what has been the drivers of making those strategies successful. Well.

As I mentioned, I wanted to be able to make money in all market environments, so you need a tool set to do that. So our strategies are equity long short converts, credit, event merger, volatility trading.

This isn't just I'm going to buy the S and P five hundred and put it away for a decade. You're active traders, and you're really looking to take advantage of situations where you have a fairly good idea of what the outcome is going to look like. It's not hey, this is open ended. Usually you're pretty confident in here's what our range of potential outcomes are.

I think that, especially in today's world, you have to understand what your edge is versus the machines. And a machine can calculate risk based on historical precedent, but a machine cannot calculate risk based upon some kind of uncertainty due to some kind of event, callous or change that's coming up because it's new. So the machine doesn't have the ability to calibrate for something that's new. And so generally across all our strategies, that's what we're focused on,

So that's the fundamental criticism of models. All models assume that the world in the future is going to look like the world in the past. Risk management is what happens if the world doesn't look like out at.

Us precisely, And that's why we don't use the standard risk management models. I actually created a statistic, the Gerber statistic, that helps to understand diversification between our deal codes, between our investment positions. A lot of our competitors are tied to factor based modeling, which ultimately, underneath it is reliant on regression analysis. Regressions. Our straight line fits through normalized sets of data, and human relationships don't file straight lines,

So let's talk a little bit about the Gerber statistic. You had this validated by Harry Markowitz, the creator of modern portfolio folio theory. Tell us about that collaboration and break down the Garberg statistic a little bit. How do you guys actually use it?

So, because of my distrust of models, based upon my experience on the floor, in particularly the guts of the models, I never believed in the correlation statistic, that correlation is predictive, and this was I thought one of the underpinnings of modern portfolio theory that you look at the expected return of the stock, the expected variants of the stock, and the covariance of correlation between the different components of a portfolio.

So if you look at the fomb of French model, which started out as two or three factors and then became five fact.

And then grow and grow. If you speak to the research departments of bar Axioma, they'll tell you that thirty four to forty percent of a stock price movement can be explained by factors.

Okay, so that's third, let's.

Roll it a and of that third, eighty five percent of that third can be explained by the first five factors, okay, which means giving credit to five, which that's bar Naxioma tells you eighty five percent of the forty percent can be explained by five factors, which means the other twenty factors explain the fifteen percent of forty percent of the words. Six percent of a stock price movement can be explained

So so I want to guess the two factors. If I had a guess, I'm going to rely on a paper by Wes Gray of Alpha Architect and guess it's value and momentum. But I'm curious what you feel.

Well, actually, Harry thought it was market. I think his market and section.

So is market and sector. But are those really factors? Do we really The.

Whole idea of factors is kind of like, you know, a little nonsense. It's like beta, you know, like market we think of as beta. It's now been called a factor.

So oh, I never really thought of beta as a factor. It's just it's, hey, if you do nothing, you get But that's market, you know, So huh, that's really it. So you're looking at the sector it's in and the overall market as the two driving facts.

I think those are Now it's true that momentum, value, these other things are relevant today because everyone else has glommed onto it, because we have so many statistical, process driven strategies that try to trade momentum. You know, buy cheap,

Now.

It's one thing to use a model to trade because the model's telling you something is some expensive or cheap.

And relative to history.

Right, And if something's always cheap, you just adjust the model. So there's a validity to that. But that's different than using the same model for risk management. Risk management, again, is about avoiding unexpected loss.

Huh. That's really interesting. So when I started on a trading desk, one of the things that I was always taught, which I never contextualized as a factor, is, hey, what's driving the stock? Well, the stock is only a tiny part of it. The stock is twenty percent, the sector is thirty percent, and half is the market. So you could be the greatest stock in the world. If the market's going down, it doesn't matter, and it could be a really good stock. But if it's in a terrible sector.

That's right, that's right. And you know, in our at Hudson Bay, we seek to produce the alpha. So it's true that the market is moving the stock, but we try to pick stocks that outperform the market or pick shorts that will go down more than the market. So we seek to focus on the alpha provision.

So let's talk about something related to this. A paper you published, environment eats culture for lunch. It sounds like the environment is what the market's doing with the sector is, but give us a little detail about.

Well, actually, I mean that that paper was related to the human aspect, not the market. So Peter Drucker came up with this idea that culture eats strategy for breakfast that corporate culture is actually more important than corporate strategy for the success of a firm. I think there's a lot to that that, you know, the way people work together in an organization. But I've always thought that this

Fun data driven? It's all about data, So you come up.

On data driven. It's not a culture. Data driven is a process. But I'm talking about what's the human aspect of it? What's what's the human culture.

I'm the wrong person to ask that, right.

Because because no one can really describe corporate culture, what you can describe as an environment. What is the environment that people work within? And I kind of learned this at Band and Company because Baine was described as this like fun loving place, everyone has fun. And then when I was there, two guys died on the locker bee crash and Bill Bayn had milked the esop and so

So the corporate culture was with pacious greed, well did you know, and almost destroy.

It was inauthentic. And when people try to describe culture, they can't. And so what I wanted to do was to describe an environment. What is the environment that you want to work within? And you know when you speak to when you speak to people on other firms, what's your corporate culture? What's your value statements? Usually these things go on and on and on. No one can really remember all the value statement. If you can't remember your value statement, it has no value.

I'm going to imagine that twenty two twenty three when all the big firms were saying, we want our employees back in the office. We don't want any more remote work. It's a matter of corporate culture. How did you think about that? Was this a legitimate demand and is it not so much corporate culture? But we want an environment where people are in the office working together. Is that legit?

I hate going to the office and seeing people not there. I think that people should work together. On the other hand, You can't force these things. You can't force independent thinking, you can't force collaboration. You can have an environment that engenders it, and so we try to have an environment that engenders it. So it's my opinion that people who come to the office are going to succeed more than

And environment beats culture for work because the work environment is more important than some statement that nobody remembers. Correct. So you guys have let's talk a little bit about independent thought. You guys have done pretty well. When the expert's wrong. You throw five, seven, eight, and nine. You were notably up in years where most people were down. Again in Q one of twenty twenty, you guys did

Again, people are trying to assess risk based upon some kind of parametric distribution with you know, standard deviation movements, and I think that's just nonsense. The markets don't work like that. So our system enables us to weather all market environments through the deal code system by ignoring those parametric The Gerber statistic, which is the basis for the work with Harry, is a rank order statistic because it

You know, we talked a little bit about sub prime real estate and how the models it wasn't even that they broke. They were so poorly constructed they were destined to fail. You know, if you build a house really poorly, you don't need an earthquake. Eventually, it's just going to collapse under its own weight. But I have to ask you some questions about real estate because Hudson Bay has

Well, we saw beginning with the the transitory higher rates, which we thought was nonsense, right. We saw that rates were going to be higher for longer, and we had believed that the market had been anchored in this idea of ultra low rates, which was really a manipulation of the monetary system. So we started thinking about what's the implications of that, and came to the notion that the banking system would be under stress. And what's the implication

And fractionally reserving it. So it's ten to one, whatever the precise the leverage there using.

So I think that the whole fractional banking system notion is challenged, particularly in the idea of the ease of information transparency among depositors coupled with the necessity for government guarantee and moral hazards. So private credit firms like ours people invest in Hudson Bay and they know it's not a bank account, and that gives us license to deploy the money in ways that are appropriate, and so we

Huh, that's really kind of interesting. You know, Ever since the financial crisis, some of the new regulations and bank regulations directly led to the rise of private equity, private credit. You know, some of the forecasts are over the next decade, this blows up to a thirteen trillion dollar asset class.

I think we're in the third inning, early early days here, Yeah, I think so.

And it it feels like it's been so big because we started with practically nothing in that space, and the first couple of trillion dollars felt like, oh, my goodness, is just so much capital washing over this. But this seems to have happened in the past where woll banks and brokers kind of move up market, they create a void in the space they left, and private money rushes in to fill that void. Is that what's going on with private credit and real estate?

Well, it's still early in that. I think it's a golden age for real estate credit. The banks are not able to they don't have the capital now to lend, and so there's it's open season.

Huh. Really really interesting. So how do you identify opportunities in the real estate space. It seems like there are so many buildings that are half empty, and yet it's a slow motion train wreck because most of their tenants have ten or longer year leases and they're just slowly starting to recognize unless you're a super A class building, even A buildings are having a hard time attracting renewals

Well, those are big questions. And I'm from Annaburg, Michigan, and I saw how in Detroit, Detroit was going to be called the museum to the desolate city because downtown Detroit went empty when they built the Renaissance Center. Everyone moved to the Renaissance Center and left these empty, huge buildings in Detroit. And you see aspects of that now where the A buildings, the new buildings are attracting very high rents and buildings in other areas are you going empty?

So I've heard some people discuss AI as a tool, and it's not that you're going to lose your job to AI, but you're more likely to lose your job to someone working with AI. Is that a fair assessment or is it just still way too early to take.

I think we still don't know. I think AI is the greatest change in my lifetime, bigger than the Internet. I think so, yeah, really yeah, because the ability for natural language processing goes far beyond what I thought was possible. You know, I studied linguistics a bit in college. The whole idea of how we form language is a fascinating subject.

Let me push back a little bit. And I'm not necessarily saying I believe this, but so I've had this conversation over and over again with a number of different people. How are you using AI in your daily work? What are you finding? And someone who hosts a different podcast said, they created this really interesting set of prompts with AI to get an answer to how to do certain things, and the first time they got the answer, they were

I was thinking of a Wizard of Oz also while you were while you were saying that, But I don't think there's a guy behind the curtain that's giving the answers. That's why I think that it helps with the junior analysts that you have to check anyway, and it certainly speeds up the research process in ways that were not possible before, for sure, and it's only going to get better. And it may makes mistakes, but the junior analyst makes

I'm glad you brought up the attorneys, because a judge just sanctions a lawyer for using AI and in certain of his answers, and this unfortunate tendency to hallucinate. I don't think the problem was that he used AI to help him in research. He didn't double check it, and he failed to disclose that AI was plathiness.

You know, it's just plain laziness. The the AI is good for the junior person, and I think as implications for the workforce, you know, what is the workforce going to look like? Given that, maybe we don't need the same failans of junior accountants, junior lawyers, junior bankers.

How do you become a senior account lawyer, banker if you're never a junior It's a tough question. So let me give you an opportunity to update your twenty twenty one piece in investing. Don't short human judgment? Do you? Are you still holding that for you?

Absolutely? I mean we are in the human judgment business. Really, we are trying to beat the machines. We do that, as I said, through understanding uncertainty, events, catalysts, and change, and I think ultimately human judgment is superior in the machines. I hope we won't go into a Hell two thousand type situation that human judgment will always be superior. You wouldn't want to have a machine be the a in the United States. How could a machine possibly make those decisions,

You mentioned the wartime usage of AI. There was a pretty big article I don't remember. I want to say the Times, not the journal, that figured out that in the Ukraine Russian War, which started out as a conventional bombardment between tanks and mortars and anti tank weapons, over the past six twelve months, seventy percent of the casualties have been drone AI warfare driven, and it's very much a brave new world. It's not like the old world

I think so. I mean, I think that the humans always have to be on top of the machines. Machines have a lot of latitude, both to produce themselves as as well as to target. You know, the markets are different because the markets follow a behavioral dynamic. The evaluation of risk versus reward is something that I think a machine cannot do in the same way the human can.

So given some of the volatility we've been seeing in the first quarter of twenty twenty five. Has that changed how you're looking at your models, how you're viewing your approach or is it, Hey, this is just another one of those things that comes along and we have to be able to trade through.

We actually like the dislocation because the dislocation proves the models are wrong.

Well, I know you guys don't release public performance numbers, but I know you're doing much better than your benchmark this quarter. Volatility is your friend. Is that what you're saying? Because volatility disrupts traditional models and you're a non traditional model. Correct. So I know you've worked with Harry Markowitz. What other academics and what other institutions have you worked with?

Well, at Imperial College London, there's further work being done on the Gerber statistic and incorporating it. The idea of thresholding data and ways to do it to For instance, if you want to understand the significance of a stock price movement, maybe you should exclude days where there's very low volume and only include days when there's high volume. There's a variety of ways to incorporate it.

I know, I only have you for a limited amount of time. Let me jump some of my favorite questions. I ask all of our guests, what are you watching or listening to? With? What's keeping you entertained?

Recently I streamed Eastern Gate?

Oh really?

Which is I saw in the New York Times. It was this spy thriller series on the conflict between Poland and Belarus, and I wanted to understand the dynamic between it. So I thought I'd get a little entertainment and understand something I couldn't pick up here. And it's a little slapstick, but I think it's worth it.

Eastern Gate. Yes, did you happen to watch any of Fouda when that was just the most heart wrenching stuff to watch? It's so stressful.

Yeah, and pretty realistic.

Very realistic. Let's talk about mentors who helped shape your career.

I gotta give a lot of credit to Dave Patrice.

Who I know that name, who really.

Helped me get into shape. And he was on my case every day, the diet, the working out. We're workout partners, and I was thirty five forty pounds heavier, uh huh, and he got me to recognize they needed to get in shape. I thought I was in shape, but I wasn't in shape. I think I think a lot of people think they're doing okay when they could do a lot better. And he taught me I could do a lot better. And I think it's affected me overall, my

You mentioned books earlier. What are some of your favorites? What are you reading right now?

One book that I really enjoyed, which was long, was Walter Isaacson's book on Elon Musk, which I read before the election, and it made a big impact on me because I believe in questioning the experts, but must takes it to a different level. He's questioning metallurgical properties that were well grounded in science and engineering, and he's saying, why does that have to be? And oftentimes he was right that the established can census regarding properties of medals was wrong.

M really really interesting. Any of the books you want to mention?

I read The Melting Point by Frank Mackenzie recently. He was the head of Scentcom and he talked about what it was like to lead Sentcom and he also had a MA He measured in English, and he thought that his English background to be a commanding general was very helpful because I helped him to articulate better and to form consensus, you know, among his colleagues.

Really really interesting. Our final two questions what sort of advice would you give to a recent grad interested in a career in either filling the blank, investing options trading, multi strategy management. What advice would you give to them?

I think it's, you know, across all certainly service occupations, is you got to be will beat the machines, and to do that, you need to be independent thinker. You need to go against the grain, question the experts. You need to be able to do that. You need ab to work with other people, to learn from them, to expand your horizons, to expand the mosaic that you can bring to your independent thinking. And you got to be

This goes back to your corporate culture, which your environment, corporate environment, my bad, your corporate environment, think independently, collaborate and respect the individual. Correct huh? And our final question, what do you know about the world of investing in finance? Today would have been useful when you were first getting started in the early nineties.

I think that you know everything you learn in business school or economics, you can just throw out the window economics and of science. People try to portray economics as a science, and it simply is not. And so all the notions that we brought up regarding money supply, you know, Milton Freem would be turning over in his grave. Even though these principles might have some grounding, It's not scientific, you know. This is this is not a natural science.

I'm trying to remember where I'm stealing this quote from Science Advance's One Funeral at a Time. The same is true with other things that Dick Thaylor said. Rather than wait for the rest of economics to catch up with behavioral finance, I'm just going to teach it to the younger generation and it'll infiltrate much more quickly than waiting for all of my peers to accept it. Really really fascinating, Sander. Thank you for being so generous with your time. We