Inside the Secret World of Prop Traders | Noel Smith of Convex Asset Management

Episode Summary

Executive Summary: Noel Smith explains the differences between proprietary trading and hedge fund management, emphasizing that prop investing is driven by risk capital, flexibility, and niche edge cases, while raising outside assets is largely a relationship and credibility business. He argues options flow is more informative than analyst research, describes how Convex packages prop-style strategies for investors, and details why scaling, degradation, and investor expectations are central constraints.

Main Topics: Prop Trading vs. Fund Management (Priority: 5/5): Smith contrasts trading your own/firm capital with managing outside money, stressing that prop trading offers more freedom while fund management adds investor relations, marketing, and scale constraints. Backing Traders and Risk Capital (Priority: 5/5): He explains how prop firms back traders with allocated risk rather than handing over notional cash, and how compensation is usually based on profit splits that rise with trust and performance. Capital Raising Is Relationship-Driven (Priority: 5/5): Smith says raising AUM is much harder than producing returns; credibility, likability, and relationships matter more than raw performance, especially with sophisticated allocators. Options Flow as Superior Market Information (Priority: 5/5): He argues options markets reveal better forward-looking information than analysts or CNBC, and that discerning informed flow from hedging is a key edge in the business. Convex’s Strategy Set and Differentiation (Priority: 4/5): Convex aims to package prop-trading best practices into an investable hedge fund through volatility arbitrage, volatility risk premium harvesting, and other option-based strategies that most hedge funds do not run. Capacity, Scaling, and Alpha Degradation (Priority: 4/5): Smith discusses how strategies degrade with size, estimating meaningful capacity around sub-$100M for some prop/HFT styles and roughly $1B notional for Convex before returns may suffer. Track Record Presentation and Investor Expectations (Priority: 4/5): He explains why Convex excludes March-April 2020 from some presentations: the COVID launch period produced outlier results unlikely to repeat and would distort future expectations.

Key Arguments: Prop trading is fundamentally about allocating risk capital, not simply managing a pile of cash; the real issue is how much can be lost in adverse scenarios. External capital is won through trust, clarity, and rapport, not just performance; many allocators prefer managers they understand and feel comfortable with. Options markets often contain better information than traditional research because they reflect real-time positioning, hedging, and potentially informed trading. A manager can be excellent at trading and still fail at fundraising; launch success depends on timing, network, preparedness, and personality fit. Convex’s edge is taking prop-style trades and making them investable, rather than offering a conventional long-short equity product. Strategy capacity is finite; as assets grow, alpha and returns usually degrade, so firm strategy and AUM targets must be matched carefully. Outlier periods like early COVID should be contextualized or excluded when they are not representative of expected future behavior.

Data Points: Trader backing count: north of 100 traders - Smith says he has backed more than 100 traders across his career. Early firm capital contribution: $1,000 each - Example of how he and a partner initially funded their prop firm. Example risk allocation: $1 million - Illustrative amount of risk capital allocated to a trader like Bob. Example notional vs leverage: $1M Apple stock vs. $1M Apple calls = about $50M notional - Used to explain difference between risk capital and notional exposure. Example profit split: 30-35% - Starting split for a trader after initial profitability in his hypothetical example. Higher profit split: 50% - Example split once a trader reaches stronger profitability milestones. Prop capital size where scale still works: sub-$100 million - Smith says smaller prop capital can still generate meaningful returns efficiently. Typical risk at $100M capital: $20M-$40M deployed risk - He notes only part of total capital is typically risked at once. Firm net worth retained in business: 95% or more - He says he kept most of his net worth in the firm for years. VC ideas attempted: 11-13 ideas - He mentions several venture investments, most of which failed. Start date in markets: 1996 - He began on the CBOE trading floor in 1996. Public assets under management target/capacity: around $1 billion notional - He estimates this as the point where Convex strategies start to degrade meaningfully. Actual invested capital capacity: a few hundred million - Converted from notional capacity due to leverage/structure. COVID launch period: March and April 2020 excluded - He explains these months are omitted in some performance presentations because they were not representative. Example 2020 trade: Broadcom / Apple volatility trades - He describes early COVID-era trades as unusual and not repeatable. Target holding period for institutional checks: no less than 1 year, often 2 - He says meaningful institutional fundraising cycles are long. Illustrative market-maker performance: $14 billion - He cites Jane Street’s public annual profit as an example of prop/HFT scale. Illustrative hedge fund sharpe: 1.5 Sharpe is strong - He contrasts hedge fund norms with much higher prop/HFT Sharpe ratios. Illustrative high-frequency Sharpe: 20 Sharpe - Used to show how different prop/HFT can be from standard hedge funds.

Pivotal Quotes: "In the prop space, nobody cares about your 10%. Okay, that's for T-bills." — Noel Smith: Explaining that prop trading evaluates risk capital and edge, not simple percentage returns. "The economics of the capital... is not about like, here is a pile of money, it's yours. No, don't blow it up." — Noel Smith: Describing the difference between allocating risk and handing over capital outright. "Relationships, likability, and returns. They're in that order." — Noel Smith: His summary of what matters most in hedge fund capital raising.

Implications: Listeners should take away that elite trading skill does not automatically translate into fund-raising success. For managers, the real challenge is packaging edge, controlling capacity, and managing expectations with transparent, repeatable processes.