Strategies that will continue to flourish?

Hi all,

Curious on your thoughts.. what type of strategies do you envision to be sustainable and successful over the next couple of years? People have talked about how the quant strategies have started to degrade a lot of the alpha from the L/S shops. But what about other discretionary strategies like global macro/event-driven/credit/distressed or any others?

Is the hedge fund industry structurally changing such that it is becoming increasingly difficult to have any sort of edge across all strategies? Apart from quant, what's changed that's made it so much more difficult for hedge funds to make money?

Comments (40)

Dec 19, 2018

We are moving towards a world where all successful HF's (large percentage of overall AUM) will be residing in quantitative HF's. Humans will be irrelevant in the HF space in 25 years when it comes to making real-time decisions (discretionary human decision making).

Quant funds (and exceptional outliers like Warren Buffett-type fund managers) will have their cake and eat it too.

Array

    • 10
Dec 23, 2018
kumarraghu:

We are moving towards a world where all successful HF's (large percentage of overall AUM) will be residing in quantitative HF's. Humans will be irrelevant in the HF space in 25 years when it comes to making real-time decisions (discretionary human decision making).

Quant funds (and exceptional outliers like Warren Buffett-type fund managers) will have their cake and eat it too.

Guaranteed written by a kid fresh out of hs.

    • 4
Dec 23, 2018

guaranteed written by a guy who knows nothing about the HF industry

Array

    • 5
Dec 23, 2018

and has never worked in the HF industry, has probably never made a single dollar in quantitative trading, and should not write such foolish comments. A quick cursory survey of yours posts here shows that you're an Army vet who is an LP in hedge funds - cool bro! You must know so much about the industry man! I mean, I'm sure you've managed other people's money, and I'm sure you know exactly how quant funds are different from non quant funds, and I'm SURE you know that quant funds crossed 1 trillion in AUM for the first time and are eating away at overall AUM growth. I'm sure you know that hedge funds right now are struggling to do well and and are allocating more and more funds towards quantitative strategies (including crowd-sourcing).

I mean, you're an LP and an army vet, that must mean you're an Einstein, right?

/IDontThinkSoBro

maybe stick to what you're good at and don't chime in unnecessarily?

Array

    • 1
    • 10
Funniest
Dec 23, 2018
kumarraghu:

and has never worked in the HF industry, has probably never made a single dollar in quantitative trading, and should not write such foolish comments. A quick cursory survey of yours posts here shows that you're an Army vet who is an LP in hedge funds - cool bro! You must know so much about the industry man! I mean, I'm sure you've managed other people's money, and I'm sure you know exactly how quant funds are different from non quant funds, and I'm SURE you know that quant funds crossed 1 trillion in AUM for the first time and are eating away at overall AUM growth. I'm sure you know that hedge funds right now are struggling to do well and and are allocating more and more funds towards quantitative strategies (including crowd-sourcing).

I mean, you're an LP and an army vet, that must mean you're an Einstein, right?

/IDontThinkSoBro

maybe stick to what you're good at and don't chime in unnecessarily?

How triggered 1-10

    • 6
Learn More

814 questions across 165 hedge funds. 10+ Sample Pitches (Short and Long) with Template Files. The WSO Hedge Fund Interview Prep Course has everything you'll ever need to land the most coveted jobs on the buyside. Learn more.

Dec 23, 2018

nah, just spitting facts my friend

Array

    • 1
    • 2
Dec 23, 2018
kumarraghu:

nah, just spitting facts my friend

Sounds like you have a fundamental bias towards your strategy and misunderstand your small role in the bigger picture. The hedge fund business is 90% a relationship business and that's not going away. A year ago you would've been right that quant inflows are up but with the exception of Two Sigma and some other randoms quant strategies have gotten killed in the last 12 months and inflows are down significantly. Even so, the higher the proliferation of quant funds in liquid strategies the more indexing is going to become attractive when the alpha opportunities eventually get taken out of the system. The strategies that will be left are relationship-based, illiquid, distressed and special-sits...areas of the market that quant can't access. What do I know though I'm only the guy that decides whether or not you get funded.

    • 2
Dec 23, 2018

The stats do not lie, my friend. Granted, this is through 2016, but the numbers are more staggering in 2017 and 2018. (as I can't post images yet, replace each instance of "%" with "."

si%wsj%net/public/resources/images/OG-AO447_201705_SOC_20170519164644%jpg

Of course, relationships are important, and that is why an inflection point must occur before there is enough of an incentive to break a relationship and switch gears. That is now happening at record levels. Redemptions are at an all-time high from non-quant funds. The top funds (in terms of AUM management) are quant funds, and this is not even debatable because it's a straight fact. Note: quant funds are NOT performing extremely well (in fact, they are down 4% in 2018), but that has not hurt their ability to attract AUM.

Something has to give, right?

Array

    • 4
Dec 23, 2018
kumarraghu:

The stats do not lie, my friend. Granted, this is through 2016, but the numbers are more staggering in 2017 and 2018. (as I can't post images yet, replace each instance of "%" with "."

si%wsj%net/public/resources/images/OG-AO447_201705_SOC_20170519164644%jpg

Of course, relationships are important, and that is why an inflection point must occur before there is enough of an incentive to break a relationship and switch gears. That is now happening at record levels. Redemptions are at an all-time high from non-quant funds. The top funds (in terms of AUM management) are quant funds, and this is not even debatable because it's a straight fact. Note: quant funds are NOT performing extremely well (in fact, they are down 4% in 2018), but that has not hurt their ability to attract AUM.

Something has to give, right?

That's all well and good, but are there currently any quant shops that specialize in distressed debt/special sits/event driven/activism strategies which require a high level of human interaction and experience when restructuring/renegotiating debt, interacting with courts/boards/management, etc? There aren't any to my knowledge, and I don't believe (though I am not very knowledgeable about the space) they will exist anytime soon - which, I believe, is the point that @Personofwalmart was trying to make.

Questions about your first post: What do you define as a "Warren Buffett-type manager"? Deep value tilt? Long term horizon? Smart guy who constantly learns? Skilled operator? And why do you think they alone will survive (what you depict as) an industry-wide shift towards quant?

    • 4
Dec 23, 2018

As far as I know, no (no HF's are able to automate a distressed debt focused strategy), but why can't this be automated in the future? The basic premise of quant funds is simple: anything done by a human should theoretically be done better by an algorithm.

We also need to go back and define what a "quant shop" is. Currently, the split is relatively straightforward between quant and non quant shops, as HF's mandates require hedge funds to specifically be labeled as "Quant" or "non quant", but due to increased processing power and the advances in technology, this is going to definitely change. My first post did not address the current state of affairs, but the state of affairs in the future, where all signs point to the fact that firms will embrace quantitative investing and trading methods more and more.

To me, a Buffett type of Fund Manager is one who has developed a reputation of being right more often than not in the long run, to the point where in the long run, that reputation in itself helps him raise AUM. These guys will always exist, whether or not they employ quants (in other words, the belief in the Fund Manager is going to dictate things more than anything else).

Array

    • 2
Dec 23, 2018
kumarraghu:

As far as I know, no (no HF's are able to automate a distressed debt focused strategy), but why can't this be automated in the future? The basic premise of quant funds is simple: anything done by a human should theoretically be done better by an algorithm.

We also need to go back and define what a "quant shop" is. Currently, the split is relatively straightforward between quant and non quant shops, as HF's mandates require hedge funds to specifically be labeled as "Quant" or "non quant", but due to increased processing power and the advances in technology, this is going to definitely change. My first post did not address the current state of affairs, but the state of affairs in the future, where all signs point to the fact that firms will embrace quantitative investing and trading methods more and more.

To me, a Buffett type of Fund Manager is one who has developed a reputation of being right more often than not in the long run, to the point where in the long run, that reputation in itself helps him raise AUM. These guys will always exist, whether or not they employ quants (in other words, the belief in the Fund Manager is going to dictate things more than anything else).

I don't believe they can be automated in the future to the point you described earlier, where "Humans will be irrelevant in the HF space." Granted, I am not at all familiar with coding/algorithms, but I don't believe that you could substitute an algo for an experienced human in several situations:

  1. court battle about bankruptcy proceedings
  2. driving shareholder activism processes, especially when management is not receptive to the proposal
  3. negotiating a debt restructuring deal

Can I see a source about the mandates requiring the quant/non-quant distinction? Not saying you're wrong, but this is something I had not heard of or expected. I partially agree with the last sentence of your second paragraph; I have seen several long lived L/S equity funds which are beginning to incorporate quant systems, but these (currently) serve more as signaling systems, and the PM/CIO makes the final call.

To your point on Buffett type managers, I largely agree, and I think this is the main argument against the domination of the industry by quant funds. While returns are king, reputation and relationships cannot be discounted. A lot of institutional money feels safer in the hands of a human, who can justifiably explain a pocket of poor performance in an otherwise good track record, rather than a fund which runs a black box strategy

    • 6
Dec 25, 2018

You don't seem to understand how computers or algorithms work on a fundamental level...yikes pal

Learn More

814 questions across 165 hedge funds. 10+ Sample Pitches (Short and Long) with Template Files. The WSO Hedge Fund Interview Prep Course has everything you'll ever need to land the most coveted jobs on the buyside. Learn more.

Dec 20, 2018

IMO, there will be two types of funds in the future:
1- Quant/ai only funds
2- human + quant/ai funds

    • 1
Dec 23, 2018

Even quant/ai funds, in the current paradigm, have some human decision making going on, although that "human" involvement is going down (which strategies do you pick to trade? Even that is going to eventually be fully automated by hedge funds willing the push the button and differentiate themselves)

Array

    • 2
Dec 20, 2018

I don't necesarily agree with the prevailing sentiment here of "L/S Equity is dead, the future is quants". I think what's happening now with the shutdowns is just an issue of a) cyclicality and b) over saturation (these aren't new ideas of mine, others have talked about this before so I won't pretend to take credit). On a), people get complacent in a long bull market with low vol (#shortvix) and don't think 2&20 is worth paying when the best trade is long the indices. On b), there are a ton of funds out there and, as with all markets, when there's decreased demand, supply will decrease shortly thereafter. Judging by this December, I wouldn't be surprised to see L/S come back into vogue over the next few years.

I think it's fair to say quant/ai will play a more prominently role in all strategies going forward, but this is more of a general global trend not specific to the HF industry in my view so not sure why we should be worried about this.

    • 5
Dec 23, 2018

It's funny, I just discussing more or less the same question at a dinner with some very smart people. The answer is "depends in what area", but here are a few interesting points that people brought up today:
- besides crowding (which is certainly real), it's possible that the recent underperformance of the HF industry is due to relative lack of volatility. Now that the QE is more or less over, we can probably see some opportunities (as it was phrased, "the oversupply of long vol from the Fed Put is now gone"
- multi-manager model is not really working for most of the industry due to lack of economy of scale and misaligned PM incentives. In the near future we might see a return of single-manager multi-strat funds that are also mixing quant and discretionary under a single roof.
- capacity constrained strategies are very interesting to invest in, but bigger players are finding it hard to attract these managers and so far nobody seen a good model to do so. Larger platforms don't want small PMs due to the netting risk while capacity constrained traders are not willing to work for other PMs due to IP leakage.
- the LS business will gradually shift towards true market neutral approach, since it's not fair to charge investors for access to beta. A lot of managers will not be able to cope.

PS. I am too drunk to sleep :/

    • 7
Dec 25, 2018

Can you please elaborate more on these points

Larger platforms don't want small PMs due to the netting risk while capacity constrained

What do you mean by "netting risk" in this context?

capacity constrained traders are not willing to work for other PMs due to IP leakage.

If you are a quant trader working on such a strategy, can't you just wait out your non-compete and then move to the new PM with your own IP ? Or maybe I am missing your point again?

People in 1903 thought horses will always be needed.
Dec 25, 2018
slumbering_programmer:

Larger platforms don't want small PMs due to the netting risk while capacity constrained
What do you mean by "netting risk" in this context?

When you are working for a platform like MLP, you have a contractual payout that is passed-through through to investors. Now imagine that you have 2 PMs, one of whom is up and one of whom is down - the platform has to pay the PM that's up and adsorbs the losses from the PM that's down. If instead you had a senior PM with a large team of traders, the PM does the netting and it's beneficial for the platform. Because of that, most platforms prefer larger PM teams (there are other arguments for it, like the economy of scale etc).

slumbering_programmer:

capacity constrained traders are not willing to work for other PMs due to IP leakage.
If you are a quant trader working on such a strategy, can't you just wait out your non-compete and then move to the new PM with your own IP ? Or maybe I am missing your point again?

Imagine that you have found interesting strategy that can produce up to 5 million a year. You probably want to keep it as hush-hush as possible so your alpha does not decay. If you go to work for another PM, he now knows what you do and even if you leave he can probably continue doing it. So you get fucked from both ends - on one side, you now will have alpha dilution and on the other side you are not making enough money to get paid really well.

    • 2
Dec 25, 2018

Lets assume the platform takes no fees and just gives back profits to investors.

So in the 2 PM case, say PM1 makes 3, and PM2 makes -1. PM1's investors get 3, and PM2's investors get 0 (platform pays 1 to cover PM2's losses). Average investor profit is 2, but it has some variance.

In the 1 PM case, the same traders would make a total profit of 2 (3 - 1) and the platform will give it back to the investors, but the payout has no variance now.

So is this the difference? Also, why can't the platform do some accounting and just "net" the profits on top of what each PM earns anyway ?

People in 1903 thought horses will always be needed.
Dec 25, 2018

They have to pay the pm 20%. So yes to the investor they do netting.

That being said they already do this with a lot of strategies so I'm not sure why it's a specific problem for "capacity constrained". The big issue i see is capacity constrained doesn't need a huge capital base to operate. I'm honestly kinda confused on his points. But it would seem that the capacity constrained can't tbose end up at the big prop shops.

But yes the netting issues exists and it will be interesting to see some of the multi-strat numbers this and what kind of fees they tack on.

Array
Dec 25, 2018
traderlife:

That being said they already do this with a lot of strategies so I'm not sure why it's a specific problem for "capacity constrained".

The smaller capacity per book, the higher number of book-runners you need. If each book runner is on a PM contract, probabilistically that leads to higher netting risk (the expected netting loss would be proportional to the number of PMs and inversely proportional to the square root of their average Sharpe ratio, or something like that). That's why platforms that are willing to take capacity constrained PMs (let's say TRC) usually require very high Sharpe ratios.

The reason why capacity constrained strategies are interesting to the platforms it is usually less correlated and more stable alpha. Platforms rightly perceive that crowding/correlation/contagion is their main risk.

    • 1
Dec 25, 2018

Thanks to @traderlife I figured it out: I was missing the 20% asymmetric incentive fee point for PMs. Now it makes complete sense. Cheers

People in 1903 thought horses will always be needed.
Dec 26, 2018

I would think netting risks is as present with 20 pods as 300 pods. Bigger issue I would have thought was why bother with a $5 million profit. Just doesn't move the needle and you need to pay a lot more managers to do selection.

That being said there seems to be hundreds of capital backers for those types of things. Just maybe limited interest from the largest managers.

Array
Dec 26, 2018

$5m moves the needle when you have 50 or 100 of them...

Also these are usually very high sharpe ratios so you pretty much never have a down month (or even week).

Dec 26, 2018

Why would someone with a high sharpe ratio generating low pnl....want to be on a platform? I've never heard of any of those shops paying out 50-80%. If you are limited to $5 million in profit then should be better places to trade.

Array
Dec 27, 2018
traderlife:

I've never heard of any of those shops paying out 50-80%.

Then you are not talking to the right ones. The people with these types of strategies get their picks for the best deals (understandably because high sharpe strategies are essentially no-risk free money for the shop taking them in).

Dec 27, 2018

Are you talking hedge funds or prop funds. By never hearing if anyone I meant hedge funds like millennium. Not the 100 or so prop type funds specializing in these things.

Also it getting riskier in these strategies. Seems like things are blowing up a lot more.

Array
Dec 27, 2018

the difference between a hedge fund and a prop shop can be blurred.

Hedge fund gives access to larger amounts of capital, which is necessary to have access to certain instruments (eg..you need over 1 billion USD to get an ISDA to trade an interest rate swap). If your strategy is HFT, or does not carry large portfolios of positions overnight, then you can get away with less capital and more leverage (but there are risks there.

Prop funds where you put up first loss capital, you can keep 70-90% of your gains, offer ridiculous leverage, but you eat 100% of your losses (works great if you make $$...kills you if you lose)

If you don't need the large balance sheet of a hedge fund /asset manager to make the same P&L of a constrained strategy, then a prop fund will pay you more for the same work. There is a risk vs reward calc to consider.

just google it...you're welcome

Dec 27, 2018

So basically yes the hypothetical $5 million a year constrained strategy would be at a prop shop and not a hedge fund.

Also a prop shop has to take 20% of losses. Or it's not a prop shop. Maybe if it's equities only but cme and cbot have strict rules that firm has to take 20% loss.

First loss capital is something completely different. And honestly I have no idea who would be interested in that source of capital.

Array
Dec 27, 2018

the definition of a prop trading firm is pretty loose. There are prop firms where you put up 100k of 1st loss capital, and the prop firm will give you 100x leverage, and eat any of your losses beyond the capital you put up (if you lose it all in a moment before the risk manager has a chance to stop you out)...and then you split 70-90% of the profits.

If you are not putting up 1st loss capital, then the profit splits are more like 20-50% (it makes sense for the owner of the capital who is taking all the risk to take most of the profits)...this is the same structure as a typical hedge fund, but with no external investors...all the $$ comes from the owner of the fund (usually a former trader with $$ who is diversifying by bringing on traders to trade his capital).

If you have confidence in your trading strategy, where you don't think you'll need to worry about drawdowns, then putting up 1st loss capital for access to leverage and market access, in exchange for a higher % payout makes sense.

i know many people who are not only interested in 1st loss capital (and the infrastructure of the firm that goes with it)...but indeed operate under this model and do very well (both capacity constrained strategies, as well as traders who are not able to get hired by the larger multi-manager platform hedge funds / asset managers...older guys, guys who were blackballed out of the industry, guys who didn't politic well...guys who just don't have a relationship with the right people, but have a strategy to trade).

just google it...you're welcome

Dec 27, 2018

Like what kind of strategy? I can't think of anything I know where it's worth taking the extra leverage in return for giving up a percent when your taking all of the risks.

There's a thousand clearing firms you can go to on futures for 100% risks and 100% reward. And on those you get a minimum of 10 times leverage on overnight positions and likely 20-50 on day trading.

Is there some kind of pair trading in individual names where that makes sense to take first loss capital? Anyone with enough money to do first loss I'd assume has enough to just start their own firm.

Array
Dec 27, 2018

there are other securities besides stocks....the bond market...other derivatives besides futures, etc...things that you need 50mm minimum capital to play. If you want to trade bond spreads, you can't do that with interactive brokers.

just google it...you're welcome

Dec 28, 2018

No one comparing to ib. The question was why is first loss ever useful?

And yes everyone knows it's tough to get access to cash spreads without being at a big fund or bigger prop place.

It can be found though for about 30k a year at smaller brokers. Margin is excessive to do on own.

Array
Dec 23, 2018

Illiquid credit. Technically not a hedge fund strat but would be very difficult for this to ever be automated

Most Helpful
Dec 23, 2018

I guess this question really comes down to what you think hedge funds do. Originally, global macro and equity long-short funds had information asymmetries that allowed them to outperform the market (at least at times). I know some excellent stock-pickers, but all of their knowledge can be programmed into an algorithm. Even very traditional l/s guys have invested massively into technology (guys like Maverick, for instance, who essentially had to reinvent themselves to survive). I think that if you want to compete on the quality of your analysis, that's a game a human loses in the near-term to a machine.

I started my career as a global macro trader and got out of the business early precisely because it was a long-term losing gambit. It was clear to me more than a decade ago that I wouldn't make it to 40 before all the macro PMs were put out of business. I still have some friends who trade for top funds, and I wish them luck over the next few years because I don't see a lot of LPs writing checks to open new macro funds 5 years from now, so they need to make their money while they can. As it turns out, being a trader doesn't really prepare you for doing anything else with your career.

That said, there are a lot of dumb LPs. The best talent in finance doesn't generally go into endowment, pension fund, foundation or family office investing. At least, historically, that was the case. We have definitely seen a professionalization of the space over the past decade, but there are plenty of hangovers from the old days whom I wouldn't trust to babysit a box of Fruit Loops let alone my money. The problem is, there is money all over the place. It doesn't just sit in NY, SF, Chicago, etc. There is endowment money in Indianapolis, St. Louis, KC, Omaha, etc. But there aren't a lot of analyst or associate programs or any investment banks in those cities, so there isn't a meaningfully-sized pool of juniors to take up positions within the LP community in those cities, so the institutional investors rely more heavily on investment consultants than they probably should. And those investment consultants aren't exactly top talent either.

One of the guys above mentioned how much of a relationship game the HF space really is. This is true for the vast majority of private investments. It's all about your ability to raise and retain capital. But CIOs aren't placing new money with under-performing managers against the advice of their investment consultants just based on relationships. Track record trumps relationships, and huge swaths of HF strategies have just sucked recently.

The argument used to be that hedge funds generate alpha, outperfoming in all market conditions. That story has morphed, with IR spin doctors now claiming they're 'hedge' funds and that their performance in bull markets might underperform and their performance in bear markets should outperform. But that's not true at most funds. There are loads of funds out there just swinging for the fences, missing, and proving they're really offering levered beta. No one should be paying any sort of management fee for levered beta.

But those same LPs are going to keep trying to beat not just the market, but one another, so they're going to keep trying to pick winners. You see, a lot of their pay packages are not just based on outperformance over some market benchmark, but how they compare to a specific peer group. If you're a not-for-profit hospital endowment, for instance, you're going to be compared against other similarly sized endowments at peer institutions. So long as their asset allocation doesn't materially change, you have little incentive to alter yours because even if you're right, you're not going to get compensated much better than if you're just slightly better than your peers.

While there may be anecdotes of CIOs operating differently, in aggregate, you tend to see their incentive structures more or less play out as I just described, so it may take a decade or more before you really see the death of many strategies. That gives some funds enough time to reinvent themselves and survive. As a result, I don't think it will all be pure quant funds in the future, but all funds are going to be more quantitatively-driven, and the ones that survive will be the ones who have invested and continue to invest in technology.

If you want to work in markets in the future, you'd be far better off getting an engineering, math or physics degree than anything else.

    • 8
Dec 23, 2018

most of the comments here are focused on the "asset side" of edge, but the "funding" side is more durable, just like with any bank the best advantage is a great depositor (funding) base. The only enduring edge for any fund or strategy is having permanent capital. The second assumptions most L/S and quant masters of the universe implicitly presume is that alpha comes from being smarter and faster than the next guy in nyc. in reality having an investment culture that emphasizes common sense and being less dumb can be good enough.

Dec 24, 2018

I think for the hedge fund model it's becoming increasingly clear that you need to be the fastest guy. Maybe this year is an outlier but it seems to me simply making smart decisions won't cut it due to the fact that almost all hedge funds run some sort of leverage.

It's the whole drunkenmiller price-signal relationship breaking down.

In two months time it's quite possible that oil is down 50%. Apple is down 50%. Amazon is down 50%. Banks are down 50%.

As I type this all these things are within shouting distance. Now I might agree that these things were too "high".

Any human hedge fund running money leveraged will be getting crushed. Honestly something is deeply wrong with market structure. I think it's coming from quant land. But part of me think quants are pushing out fundamental guys cuz funds guys can't manage risks in this.

Also I think fama-French might be dead. Sort of by the if too many people are watching a signal it becomes meaningless. But I'd have to do more analysis. Strange factor moves all year. And I don't for an instant understand how a momentum factor can work now. Seems like I see stocks that were momentum turn into zeroes in a short time.

Array
    • 1
Dec 24, 2018

Shareholder Activism

Dec 27, 2018
    • 2
    • 1
Dec 27, 2018