Lessons Learned from Situational Awareness LP

Three Lessons from the Year’s Most Dramatic Hedge Fund Drawdown

We will admit to our readers that we knew nothing about Situational Awareness LP prior to its spectacular drawdown in July. Nor did we know much about its founder, Leopold Aschenbrenner.

Before we get into the lessons, here’s a little background on the hedge fund and Mr. Aschenbrenner.

He is a 24-year-old German who graduated as valedictorian from Columbia University with a degree in economics and mathematics-statistics. He received that degree in 2021, when he was only 19 years old. Based on those facts alone, it is reasonable to assume that Mr. Aschenbrenner is an extremely intelligent person.

Before starting Situational Awareness LP, he worked at the FTX Future Fund and OpenAI. The hedge fund launched in 2024 with prominent backers and grew at an extraordinary pace. It reached approximately $45 billion in assets before its July 2026 crisis.

A little more about the hedge fund: it was a long-short hedge fund with extremely high gross exposure. Its intended portfolio could reach roughly 200% long and 200% short. In other words, that is around 400% gross exposure. Applied to $45 billion of capital, that would correspond conceptually to about $90 billion in long positions and $90 billion in short positions. We do not know that these were the fund’s exact positions at any particular point. However, they illustrate the scale of the leverage involved.

Before the July drawdown, the fund’s 2026 return was about 450%. Following a 67% drop in July, the fund was still approximately 80% up for the year. The fund sold most of its public-equity portfolio and eliminated its leverage rather than disappearing altogether. So, yes, despite an extraordinary drawdown, investors who had been there from the beginning of 2026 were still significantly ahead. They were just dramatically less so than they had been at the peak.

Lesson 1: Very high targeted annual returns usually come with very high annual standard deviation

The Sharpe ratio is a useful way to think about the relationship between excess return and volatility. A strategy generating a 50% annual return with a Sharpe ratio of 0.5 would require approximately 100% annualized volatility. That is, ignoring the risk-free rate for simplicity. Even with an exceptionally strong Sharpe ratio of 1.5, the implied volatility would still be roughly 33%.

Annualized volatility of 100% corresponds to approximately 29% monthly volatility. A two-standard-deviation negative month would therefore be close to a 58% loss. Even at 33% annualized volatility, monthly volatility would be roughly 10%, making a two-standard-deviation negative month approximately 20%.

That’s how markets work – higher expected returns generally require accepting higher expected risk.

As targeted returns become extreme, however, simple normal-distribution calculations become less useful. Leverage, margin calls, liquidity constraints, correlations that suddenly change and fat-tailed market moves begin to dominate the mathematics. At sufficiently high leverage, you do not need an extraordinary move in the underlying assets to create an extraordinary loss in the portfolio.

Of course, a really, really smart portfolio manager may be able to produce better risk-adjusted returns. But there are limits. When observed returns become several hundred percent per year, perhaps our first question should not be, “How much alpha is this?” but rather, “How much risk must be hiding underneath?”

It seemed to us that Situational Awareness’s exceptional performance before July told us something important about the risk being taken. The fund was highly leveraged, concentrated in volatile assets and exposed to a portfolio structure capable of producing enormous gains. It could also produce enormous losses.

Lesson 2: 200% long by 200% short requires extraordinarily careful management of correlation and risk

A long-short portfolio by itself is nothing unusual. What matters is gross exposure, the volatility of the individual positions and, critically, the correlations between the long and short books.

A portfolio that is 200% long and 200% short has 400% gross exposure. That is considerably more aggressive than the roughly 150–200% gross exposure commonly associated with many traditional equity long-short hedge funds.

Such extreme gross exposure becomes considerably less dangerous when the long and short assets are very highly correlated. Think, for example, of a relative-value position involving XOM and CVX. A 10% market-wide move may affect both sides similarly. As a result, the portfolio may be left primarily exposed to the relative performance between the two securities.

But Situational Awareness was doing something quite different. Its basic trade was heavily long AI infrastructure and related stocks while shorting software companies expected to be disrupted by AI. Those positions may fit beautifully into the same investment thesis. However, that does not mean their prices will remain highly correlated.

That distinction is crucial.

When both sides of a 200% long / 200% short portfolio move against you simultaneously, being “market neutral” provides very little comfort. The long book can fall while the short book rises. Moreover, leverage magnifies both mistakes at the same time.

Had the same fundamental thesis been expressed with substantially lower gross exposure (say 100% long and 100% short rather than 200% long and 200% short), the July drawdown would mechanically have been much smaller, all else being equal. Returns on the way up would also have been lower, of course.

And perhaps that is exactly the point. Meanwhile, Situational Awareness LP’s approach highlights how leverage magnifies both gains and losses in volatile markets.

Lesson 3: Margin of safety is often learned by experiencing a significant financial loss. Geniuses are not exempt.

Fortunately or unfortunately, one of the best predictors of how a person will handle a specific task is prior experience. That is true for pilots, portfolio managers and traders.

Mr. Aschenbrenner appears to be an exceptionally intelligent young man. But when he started Situational Awareness, he had very little professional investment-management experience.

Intelligence can help somebody understand risk intellectually. Experience teaches something slightly different: what risk feels like when positions are moving against you, liquidity is disappearing, correlations are changing and lenders want their money back.

That distinction matters.

A portfolio can be mathematically sound under ordinary conditions and still become impossible to manage under extraordinary ones. Margin of safety exists precisely because our assumptions about volatility, correlation and liquidity will occasionally be wrong.

Intelligence is no substitute for experience.

And perhaps the most valuable lesson from Situational Awareness is that the market occasionally charges a very high tuition fee for teaching that distinction.

Disclaimer