Wearing jeans, sneakers and a backpack, his hair rumpled and his T-shirt turned inside out to hide the logo, Merritt Graves looked like any other carefree undergrad as he strolled across the bucolic Pomona College campus in Claremont, California, climbed the steps of the Carnegie Building and took a seat in class. If attendance at his energy economics and policy course was a little thin that April morning, the professor joked, it might have been the fallout from the previous week’s midterm exam.
Graves, who got a B+ on the test, pulled out a notebook and began copying key provisions of the Natural Gas Act of 1938 from the blackboard, along with the diagram of the flow of gas from the ground to the end consumer. The course is one of two that Graves is taking this semester, both electives for his major in environmental analysis.
“One of the key institutions the Founding Fathers agreed with in the U.S. Constitution was free trade,” said the professor, John Jurewitz, a senior economist with electric utility Southern California Edison, as he dove into a lecture on the history of natural-gas regulation.
Gradually, Graves’s attention began to drift. He glanced discreetly at his iPhone, tapping the screen. But Graves wasn’t texting friends about a big night out or checking status updates on Facebook. The 23-year-old, who tracks nearly 100 trading positions on his phone’s Web browser, was monitoring the stock market, which by that time had been open for more than three hours.
This college student has an unlikely full-time job: He runs a $4.7 million long-short equity hedge fund.
In themselves, the numbers put up by Caelum Capital, as Graves’s five-person firm is known, are impressive. For a fund piloted by a kid who has no professional investment training and who only recently moved out of the dorms, they are uncanny. Last year, when the average equity hedge fund manager was down 26.4 percent, according to Chicago-based Hedge Fund Research, Graves was up 40.6 percent. In 2007 he returned 174.1 percent, after more than tripling his money the previous year — and nearly doubling it the year before that.
Graves called the subprime mortgage crisis and its impact as early as 2005. He also predicted the severe stresses that hit the banking sector in 2008.
As Caelum’s sole investment professional, Graves has achieved this remarkable record not by shooting for the moon but by maintaining tight risk controls. In addition to holding a diversified portfolio of 80 to 100 stocks, he limits each position to 0.5 to 8 percent of the total and won’t borrow more than 2-to-1 overnight. His fund’s net market exposure — his longs minus his shorts — has typically ranged from –30 percent to 30 percent of the portfolio’s total market value. As a result he has delivered far less volatility on the downside than either the Standard & Poor’s 500 index or the Nasdaq composite index, and his fund’s returns are relatively independent of both benchmarks.
“It has been a long road of constantly getting more disciplined,” says Graves, sounding more like a grizzled money manager than an undergrad who still eats in a college cafeteria.
Monitoring the markets while attending class is something that Graves has been doing since junior high school, when he learned formative lessons about risk. At age 14 he convinced his parents to help him open an account at discount brokerage Ameritrade — and twice lost all his savings from odd jobs as the technology bubble collapsed. In 2002, at age 17, he borrowed $7,000 from a local day trader he had befriended and lost it all again.
“It hurt so much worse losing someone else’s money,” recalls Graves.
After taking a year off from trading to study the markets, the then-teen summoned the courage to borrow another $7,000 from the same individual, who agreed to give him a shot at making up the prior loss in exchange for half of any additional trading profits.
It proved to be a smart bet. Within a year Graves had turned the $7,000 into $340,000, netting a personal profit of $100,000 after taxes. His winning streak continued as he began studies at the University of Iowa, spent a year abroad at Australian National University and took 12 months off to live in Berkeley, California, to focus on his trading before continuing his education at Pomona. During that three-and-a-half-year period, he turned the $100,000 into $2.8 million, which he used to seed Caelum Capital in October 2007.
Arguably Graves’s greatest strength, developed through trial and error, is his ability to interpret buy and sell signals from security-price movements — in short, to “read the tape,” a skill that is tough to teach and that he shares with hedge fund stars who are more than twice his age, like SAC Capital founder Steven Cohen and Paul Tudor Jones II of Tudor Investment Corp.
“Intuitively, I started to feel what the market was doing,” says Graves, reflecting on his evolution as a trader. “Things started to become more visceral.”
He is hardly the first hedge fund manager to start young. Renowned investor Michael Steinhardt began trading when he was 13. Kenneth Griffin, who founded Citadel Investment Group when he was 22, famously began trading out of his dorm room at Harvard University. And Warren Lichtenstein launched activist fund Steel Partners when he was 24. But unlike Graves, all three attended Ivy League institutions. Steinhardt and Lichtenstein worked for other firms, albeit briefly, before going it alone. Griffin was backed by a well-known fund of funds and also had the luck to start his firm in the 1990s, when the hedge fund industry was embarking on a period of rapid asset growth.
Like Steinhardt, who grew up in Brooklyn, New York, Graves has working-class roots. He also lacks the kind of connections that Griffin and Lichtenstein had. Nor does he have the good fortune to be launching a fund in an era of ample liquidity. Born and raised in Iowa City, he is the son of an elementary-school teacher and a radiology engineer who can’t invest in their son’s fund because they don’t meet either the six-figure-income requirement or $1 million net worth threshold for accredited investors.
“We really weren’t familiar with hedge funds; we had to learn what one was,” says Graves’s mother, Leanne.
“It was all new to us,” adds his father, Joe. “We don’t watch the stock market.”
The younger Graves could have finished college, joined a hedge fund as a junior analyst and worked his way up the ranks before going out on his own. In fact, his parents might have preferred that path. But it was never an option.
“Would a hedge fund have paid me $2 million over the past two years?” he asks rhetorically.
Not that Graves is motivated by wealth. His clothes are often secondhand, and he sometimes shops with coupons. He still drives the same 2000 Pontiac Grand Am that he had in high school and uses his trading profits to fund a business called Farmscape, which helps homeowners create their own organic vegetable gardens. Until May, when he moved into an apartment with friends and Caelum Capital employees Scott King and Jon Bassett, as well as Bassett’s new puppy, Bailey, Graves was living in a dorm room so spartan that its only distinguishing feature was an electric keyboard, which he uses to compose music, a much-needed distraction from investing.
Graves’s goal over the next year is to grow Caelum’s assets under management to $25 million, a modest sum by hedge fund standards but a leap of faith for a speck of a firm in a $1.3 trillion industry expected to shrink by as much as one third. The stress of achieving this shows in Graves’s wrinkled brow, the worried look in his eyes and the constant flickering of his attention as he checks the virtual tape on his iPhone. He doesn’t sleep much these days.
“You definitely think about the people you are responsible for and the investors who are counting on you,” says Graves, who admits that he sometimes regrets not having pursued a more typical college experience. Still, he says, “I am definitely going to do my best.”
Back in class, after Jurewitz wrapped up his lecture on the natural-gas market, half a dozen students rushed to the front of the room to pepper the professor with questions. But Graves had the market on his mind and headed out into the Southern California sunshine for the short walk through Pomona’s Spanish-style campus to Caelum Capital’s office, situated in a converted brown-brick theater nearby that also houses a nail salon and a restaurant.
The one-room space, located upstairs, is utilitarian, quiet and costs just $800 a month. Insulation and roof beams poke through the unfinished ceiling. A few books and magazines are scattered about, and no pictures hang on the bare brick walls. Five desks are spread around the room for Graves, whose spot is dominated by four PC screens that he uses to trade, and his Caelum Capital colleagues: Bassett and Connor Donnelly, both 23, who handle sales and marketing, and Dan Allen, who turns 24 in July and has been serving as the firm’s COO. Graves, Allen and Bassett are friends from high school. Donnelly got to know Bassett at Davidson College in North Carolina, which the two attended on sports scholarships, and met Graves when the Iowa native came to Davidson for a visit. King, also a high school friend, joined the group in Claremont in May.
“I remember thinking what a nice, humble guy Merritt was,” recalls Donnelly, who interned at a small long-short equity firm in Seattle, Washington, and is the only member of the team with any prior hedge fund experience (last month he decided to move back to Seattle and is now working remotely for the firm).
Running a hedge fund while attending college is a constant juggling act. To balance his workload, Graves takes just two courses a semester and won’t complete his bachelor’s degree until 2011. His grade-point average has slipped only slightly from a perfect 4.0 since the launch of the fund, and he remains engaged in academics, often dropping by to visit his favorite professor, Richard Hazlett, who coordinates Pomona’s interdisciplinary major in environmental analysis.
It was in Hazlett’s class that Graves developed the idea for Farmscape, which employs two friends of the Caelum team and is just beginning to work with its first customers. For a fee that typically runs $99 a month, Farmscape provides an eight-by-four-foot wooden box filled with soil and planted with a selection of organic vegetables, along with a built-in irrigation system (this is Southern California, after all). Employees also help tend the garden. The goal is to help people become more self-sufficient and eat fresh, homegrown vegetables year-round. Although Graves intends to run Farmscape as a for-profit business — the key will be keeping labor costs low, he says — for now he is funding it out of his trading profits, which also cover the cost of running Caelum itself, as well as Graves’s college tuition.
“Merritt belongs to a generation of students who really are enterprising,” says Hazlett. “There is a lot of practical problem solving going on.”
Merritt Graves has always been entrepreneurial. In the fourth grade he baked cookies that he sold in the teacher’s lounge until the school district shut him down (he even had his own business cards printed up). Later he ran lawn-mowing and snow-shoveling businesses and earned money cutting down Christmas trees.
In eighth grade, while watching business network CNBC, he decided to invest his savings in the stock market, convincing his parents to open the Ameritrade account.
“I thought investing looked cool,” he says.
It was the summer of 2000, and the dot-com boom was going bust. Graves had invested his entire $500 in savings in a handful of high-flying technology companies that ended up going bankrupt. He lost everything.
Undeterred, Graves raised a new $1,000 stake by flipping burgers and running a pressure-washing business. He bought more tech stocks. He lost everything again.
By then, Graves was attending Iowa City High School, where he was a popular and engaging student with wide-ranging interests. Daphne Foreman, his ninth-grade English teacher, says Graves especially enjoyed Fahrenheit 451 , Ray Bradbury’s portrayal of a dystopia where censorship rules, identifying with the free-thinking and insatiably curious Clarisse McClellan, one of the main characters.
“Merritt was obviously concerned about things most kids weren’t,” says Foreman. “He had a presence about him.”
During his sophomore year Graves raised $7,000 from Jeff Larson, a local day trader and entrepreneur he befriended who must have sensed something special in the teen (Larson did not return phone calls seeking comment). Graves used that money, along with $2,000 of his cash, to get back into the market, this time trading small- and microcap stocks.
The third time wasn’t the charm. That spring, Foreman says, Graves began looking more and more tired, missing school entirely some days. He lost everything again. “I advised him several times to back away,” says his father.
Instead, in his quiet, determined way, the younger Graves began to monitor the market rather than trade it, teaching himself to sense where stocks were moving by watching the tape. He read about investing and behavioral finance, and identified a major weakness in his trading: a tendency to double down on declining positions in an attempt to make his money back quickly and end the pain of losses.
By July 2003 Graves was ready to try again. With the second $7,000 stake from Larson, he focused his attention on stocks with larger market capitalizations.
The following year, as he prepared to graduate from high school, Graves began shorting and trading on margin in his account. His first short, stun-gun maker Taser International, sticks in his memory.
“I was so nervous I ended up covering the next day, much sooner than I should have,” says Graves. Still, he turned a small profit on the trade.
Graves, by then a more confident and controlled trader, started college locally, at the University of Iowa, an event that marked a turning point in his investing. While studying abroad at Australian National University from the summer of 2005 to the summer of 2006 — where he traded at night because of the time difference — he made his most prescient call to date. In an e-mail to a handful of friends, he predicted the U.S. real estate collapse and the havoc it would wreak on the banking sector. House prices had formed a bubble, he argued, akin to that created by overhyped tech stocks in the previous cycle. “What he said then, it all turned out to be true,” says Allen.
Nonetheless, Graves refrained from placing a big bearish bet. “There are times when you have to hold back,” he explains. “If the market doesn’t see the same thing you are seeing, then you are going to end up losing a lot of money.”
By the time he returned from Australia, Graves had turned his original four-figure stake into about $1 million and realized that his trading strategy was scalable. He decided to take a year off from college and moved to Berkeley to set up a fund with another trader he met through a mutual friend. His mother worried about him a lot during that time. He was all alone, she says, and had few close friends to turn to or ways to escape the stress.
Not that it affected his trading. In 2006, Graves’s best year so far, he was up 308.4 percent after making some highly profitable investments, including short positions in airlines and long positions in the biotech sector and stocks that rode the run-up in energy prices.
The following year, Graves sensed that sentiment would turn. He began shorting consumer stocks and then both mortgage lenders and banks.
“He basically played out the whole credit crisis to a T,” says Doug Donnelly, Connor’s father, a Wachovia Securities financial adviser who was so impressed with Graves when he met him last summer that he became Caelum’s first outside investor.
The new business wasn’t going as well as his trades, however. Graves and his partner split after only a year. He decided to transfer to Pomona. In the fall of 2007, as the stock market and the hedge fund industry went into free fall, Graves moved to Claremont to start classes and opened Caelum. He spent three months researching prime brokers and ultimately chose New York–based boutique BTIG, which offered the most competitive trade-execution rates. (Caelum has also hired top-flight international law firm Reed Smith and accounting firm McGladrey & Pullen, based in Bloomington, Minnesota.) Over the next 18 months, Graves’s friends began joining him in Claremont to help build the firm.
“I knew we would all work together someday,” says Bassett. “It was just a question of when.”
One cool spring evening in Claremont, with the San Gabriel Mountains looming in the background, their peaks still brushed with snow, the trials and tribulations of the hedge fund industry seemed to be a million miles away. On this night, Graves and his partners had gathered at Allen’s apartment for dinner. The menu: arugula salad, fava-bean risotto and conversations ranging from Barack Obama’s presidency to the bank bailout to The Daily Show host Jon Stewart’s comedic rebuke of CNBC.
Even in an informal setting, Graves is clearly the leader of this little band. There is a friendly rivalry among the others to impress him with their opinions, to show him that they can project the same studied seriousness that he does.
His friends tease him — about his poor driving skills and never-ending college career — but they are also protective, sending him off to bed when it gets late. Tomorrow is another trading day, and he still needs to check the Asian markets.
Investing isn’t Graves’s only passion. When he moved to Pomona last year, he knew he wanted to play music seriously. Although he had been in his high school choir, Graves didn’t think he had the singing talent to cut a professional-quality record. So shortly after arriving in town, he advertised for a singer, eventually deciding on an aspiring vocalist and actor named Jeremy Bassett (no relation to Jon) who lives in Los Angeles. Now the duo is working on recording a studio album.
Graves says his musical tastes lean toward bands like Radiohead and Muse. Graves’s own music, like his trading, is remarkably professional in its production quality. One song on the album, “Novocaine,” which he composed in Berkeley, has lyrics that speak of love, pain, fear and loss:
Within me you can fall apart
Leaving pieces of your lonely heart
With Novocaine so I can’t fail
For Graves, writing and recording music has become a crucial release. He says music is practically his only escape from the markets. Since he began playing seriously, he contends, his investment performance has been more even.
These days the young hedge fund manager needs all the good karma that his melodies can provide. Although he is nearly market neutral, Graves has generally stayed bearish during the recent stock market rally, and it has cost him. In March he lost 9.2 percent but still managed to finish the first quarter up almost 10 percent. In April, though, he lost 13.9 percent, notching the second-worst down month of his audited track record, which goes back to February 2005. In May, Graves was down 1 percent.
“This is the most challenging environment that I have had to deal with,” he says. “It is not a fun one either.”
Recently, Graves has been focusing on companies that carry a heavy debt load and are likely to have difficulty refinancing. “From a debt perspective we are at a very similar spot as in the late 1920s,” he says.
One short play that he held on to through the first quarter is airlines. In March and April the stocks rallied, however, hurting Caelum. Graves still believes in his analysis, but he closed out the position and is waiting for the right moment to dive back in. He also thinks that real estate investment trusts will move lower, although he has lightened his short positions there too.
Finding investing opportunities on the long side is an ongoing challenge, given Graves’s bearish views. He likes some discount retailer stocks, such as Wal-Mart Stores, which he believes can do well in this environment. Graves also likes commodities and plans to start trading futures. “Commodities are great,” he says. “They don’t have a balance sheet and can’t take on debt.”
Over the long term, Graves is most enthusiastic about technology stocks. He also believes that solar companies will thrive, even though the economic collapse has taken the wind out of their sails. “It is tough to be long solar right now, given the economic environment,” he says.
Of course, managing money is only one part of running a successful hedge fund firm. Graves knows that serving as the sole investment professional isn’t sustainable. He has been tutoring Allen, who recently passed his Series 65 exam and handed off his COO duties to Jon Bassett so he can focus on learning to trade. (King has also taken the Series 65 exam and expects to begin trading soon.)
In the meantime Graves’s friends are busy building an infrastructure around him. Allen was the one who rented Caelum’s office space and recently completed the firm’s first compliance manual. Bassett and Donnelly, both gregarious, are well suited to sales. So far Donnelly has been the rainmaker: The majority of Caelum’s two dozen or so outside investors have come from connections that he made through his internship at the Seattle hedge fund.
Will Graves and his team succeed? The odds are certainly against them. Without a five-year track record and at least $50 million in assets, not to mention a manager with a more traditional background, Caelum is likely to attract few (if any) institutional investors at this stage in its development.
Even high-net-worth investors are a tough sell. As Graves puts it, “If you make a mistake by investing in a hedge fund run by a 23-year-old, people are going say, ‘I told you so.’”
Still, Graves and his partners are taking the challenges in stride. They recognize the odds, but their youthful optimism is a powerful elixir.
“If this doesn’t work out,” says Graves, sounding philosophical, “I could live with that, if I knew that I did everything I could.”
