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Do The Math

Updated: Jul 20, 2023

Even index funds are actively managed… by quants.


By definition, quantitative funds are investment management vehicles that employ software-driven decision-making as a core strategy. This can range from index funds tracking a benchmark to sophisticated algorithmic hedge funds, and guess what?— they’re all competing for the same talent.


The way an index fund makes its money is by making just a few basis points more than the index that it’s charged with replicating. Since their inception, index mutual funds have functioned by having a bunch of math and computer science geniuses sitting around thinking about ways to shave off milliseconds in order to perpetuate this arbitrage process.


Fast forward thirty years, and Wall Street is littered with high frequency traders (HFT’s); robotic traders now manage about $1 out of every $3. And hedge funds now account for close to half the trading on the New York and London stock exchanges. In 2003, there were 3,000 hedge funds managing about $500 billion; today, there are more than 11,000 hedge funds managing $3.5 trillion.


Many of the legends of the hedge fund industry have come under siege over that time. Several have closed, some have been relegated to the family office level, and a couple are subsidizing the enterprise out of their own pockets-- which is no easy thing now that hedge funds are having to pay top dollar to bring in new employees with quantitative skills in an almost desperate attempt to bulk up their abilities around big data and algorithms.


Over the last few years, recruiting at hedge funds has gone all-out to find analysts with a more and more quantitative background. Often, it's at the PhD level, with a background in math, physics, engineering or computer science. And if you ask Steve Cohen how that’s working over at his Point 72, he’ll tell you that there’s a dearth of talent out there. …Between all the death threats that he’s received this year, he’s been pretty vocal about it.


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Recruiting on university campuses like MIT, Cal Tech and Cambridge is furious, sure, but more and more often, the “new” talent is coming from mutual funds. Everybody is looking for that rock star trader (who still has his reputation intact, which is important), and with the decreasing preference for employment in mutual funds, a decline in mutual fund performance has been quantified, thus providing new evidence that some managers are just plain better than others.


It also shows that industry-specific government regulations can lead to brain drains that have crippling effects on the health of regulated mutual funds.


Many young QA’s are motivated by an environment where they can indulge their academic interests with the company of like-minded people and access to cutting edge technology. The problem for mutual funds is that there are very few that are likely to win out against hedge funds on this particular battlefield-- mutual funds are regulated and therefore cannot deliver the complex investment strategies that interest this new generation of quants. Adding hundreds of millions of dollars to chase these traders has only thrown gas on the fire.


I would say that's probably the bigger, less considered cost, that society is diverting very smart people who could be out doing serious work in science so that they can instead optimize code to make arbitrage occur a little bit faster. …That seems kind of pointless to me; there are no real benefits to having prices move a millisecond faster.


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However, for most retail investors, understanding what’s going on in the hedge fund industry can help to positively inform one’s portfolio management. As funds of all shapes and sizes have come to rely more and more on quantitative strategies, performance has suffered. Portfolios are so big that they’re having to move massive positions, and the algorithms just can’t always keep up.


And that’s why it’s really not all that surprising that the top hedge funds on Bloomberg’s list of the best performing hedge funds of 2020 are dominated by human traders. Chase Coleman’s Tiger Global generated $10.4 billion for clients, after fees, and Izzy Englander’s Millennium Management was a close second, with $10.2 billion. As LCH Investments Chairman Rick Sopher said in a statement, “In navigating the especially volatile markets of 2020, talented individual managers with vision and flexibility performed better than programmed machines.”


Most retail investors are not typically going to meet the minimums of most of the big hedge fund players. However, that doesn’t mean they have to rely completely on mutual funds. In the first place, it’s not that difficult to keep track of what any given hedge fund is buying or selling, at least on a quarterly basis, so retail investors can simply copycat them-- and save a ton on fees while doing it. …We’re generally going to charge somewhere around 1% or 1.25% a year as opposed to the traditional two-and-twenty hedge fund model (that takes a 2% annual fee plus 20% of the gains).


Using an advisory firm (like ours) makes for far more nimble portfolios anyway; liquidity is improved when one is moving smaller positions. That should mean better risk management, better control over taxation, and better prices on your trades.





For disclosure information please visit: https://www.rgbarinvestmentgroup.com/terms-and-conditions


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