Last year was a tough slog for people in the hedge fund business. Most hedge fund managers delivered their worst performance in years - with billionaire David Einhorn's Greenlight Capital hedge fund being ranked among last year’s worst performers, and hedge fund mogul Bill Ackman's Pershing Square Capital Management losing more than $2 billion on its largest stock holding Valeant Pharmaceuticals (NYSE:VRX). The industry's performance was hit so hard that the number of now-defunct hedge funds that closed in 2015 is astonishing: almost 1,000, more than in any year since the 2008 financial crunch.
Regardless of whether or not the hedge fund industry continues to lose weight, one thing is obvious: with more hedge funds than ever before, it’s simply impossible for managers to generate meaningful returns. Only those who effectively progress in tandem with the constantly evolving industry will succeed, while stagnant managers will be forced to become more efficient or leave the industry.
The jungle mentality of Wall Street is “you eat what you kill”. It’s impossible to become wealthy without making your investors wealthy. Today, the guys who still have enough on their plates are “quants”, or quantitative hedge fund managers. Even in challenging market conditions, they still managed to make money using computer algorithms instead of fundamental strategies. Some of these quants solely rely on computer models and technical analysis to tell them what to buy and sell and when to do it, as James Simons of Renaissance Technologies, while others use quantitative approach in the decision-making process or to find trend patterns in the world’s data, as does David Siegel of Two Sigma Investments.
According to the just-published “2016 Rich List of the World's Top-Earning Hedge Fund Managers” by Institutional Investor’s Alpha magazine, eight of the top ten earners on Alpha’s list fall into the “quant” category, and half of the 25 richest of the year are quants.
James Simons, a mathematician and former Cold War code breaker, has made an estimated $15.5bn from his mathematics-driven “quant” Renaissance Technologies, a hedge fund he set up 34 years ago. Simons, 78, who retired as CEO of Renaissance in 2009, is the 50th richest person in the world, according to Forbes, and is one of the biggest winners (No 2) in the 2016 “rich list” with estimated 2015 earnings of $1.7bn.
Last year, David Siegel, 54, a computer scientist and co-founder of Two Sigma Investments, one of those quants, announced that one day “no human investment manager will be able to beat the computer”. Almost a year later, Siegel manages more than $35bn. He qualified for Alpha’s “rich list” for the first time this year and debuted at No 7 with 2015 earnings of $500m. Two Sigma's Compass Enhanced Cayman Fund and its Absolute Return Fund both returned 15% (after fees) last year, when many actively managed hedge funds posted losses or weak returns.
This data shows the possible transition in the hedge fund universe from the traditional active management model – with hedge fund managers screening the markets in search of undervalued investment opportunities and then betting on them – to the quant age where investment management is outsourced to trading robots and complex computer models. In this new digital era of quantitative finance, quants couldn’t care less about a company’s intrinsic value or its fundamental position, as long as their quant models clearly point to a window of opportunity.
Top quant hedge funds with billions of dollars under management represent just a small fraction of all quant firms but manage the lion's share of the invested capital. Clearly, within the extremely competitive universe of hedge funds there are smaller quants that can outperform even seasoned investment managers, but picking them is not an easy task in an overcrowded environment. In addition, risk-avoidance and herd mentality are the reasons why most investors still prefer to allocate their money to well-established managers, yet multiple studies have shown that smaller funds tend to perform better than larger ones.
One of these smaller quants, currency trading hedge fund firm Leman Capital Management ( https://lemancapital.com ), earned a record 62 percent return in 2015 when most funds lost money. Since 2013, Leman's BVI-domiciled Quant Fund has returned an average 41 percent (net of fees) per year, including dividends. According to MarketWatch, 2015 was the third year out of the past five that the firm's total return has increased considerably compared to the previous period. The firm is a big focus again this year, with five consecutive months of positive performance.
So far this year, hedge funds that rely on computer-driven trading have continued to produce some of the highest returns in the industry. If this trend carries on through 2016, it won't take long for the hedge fund world to acknowledge that Siegel was more than correct with his prediction.
Company Name: Quantitative Finance Laboratory, Humboldt