Hedge Fund Quants Taking Over the World?
Want more proof that the quants are taking over the world? Take a gander at this chart of the world’s top 10 hedge-fund managers released Wednesday by London-based LCH Investments (click on image below).
LCH’s annual update on long-term fund performance is eagerly awaited. For 2016, the firm, which bills itself as the world’s oldest fund-of-fund investor, made an important change, including for the first time several managers that depend partly or completely on a “systems-based” investment approach—think computers and quantitative models.
Nathan Vardi of Forbes also reports, Computers Start To Take Over List Of Most Successful Hedge Funds:
With the change, D.E. Shaw & Co. made its debut in third place on the table, behind Ray Dalio’s Bridgewater Associates and George Soros’s Soros Fund Management. The table measures net gains since inception through the end of last year.
D.E. Shaw, founded by computer scientist David E. Shaw, is one of the pioneers of quant-based investing. So is Ken Griffin’s Citadel, which enters the list at No. 5. Shaw, which saw a net gain after fees of $1.2 billion in 2016 has accumulated net gains $25.3 billion since its inception in 1988. Citadel, founded two years later, saw a gain of $1 billion in 2016 and is up $25.2 billion since its inception, according to LCH’s estimates.
And all-time champ Bridgewater, while not a newcomer to the list, is famous in part for the role that systems-based trading plays in its Pure Alpha Fund. Not on the table above, but coming in at No. 20 in LCH’s estimates, is Two Sigma Investments, a systems-based fund founded in 2001 by former D.E. Shaw employees David Siegel and John Overdeck.
“The increasing capabilities of technology-based investment systems is in evidence in these results. These systems are being used by many of the most successful investment firms to provide alternative data sources, processed investment analysis and artificial intelligence,” said Rick Sopher, chairman of LCH Investments.
Of the top 20 firms, LCH estimates that D.E. Shaw, Citadel, Bridgewater and Two Sigma have accounted for $90 billion of net gains for investors over the last 10 years—a whopping 28.2% of the $319.2 billion total.
All that said, the overall returns produced by hedge-fund managers in 2016 were a disappointment, Sopher said. “Even the managers with the best long-term records did not perform strongly and their results were no better than average,” he said.
The top 20 managers generated a total of $16.1 billion in gains after fees in 2016. On a weighted basis, they produced a return of 2.6%. The S&P 500 SPX, +0.06% returned 11.9% in 2016, including dividends.
That’s in line with the general perception of 2016 as a particularly dark year for the hedge-fund industry as institutional investors and others continued to balk at the industry’s high fee structure and carp about lackluster performance amid a broader shift to passive investing.
It was a tough year for some high-profile managers. Paulson & Co., ran by billionaire John Paulson, who became famous for his lucrative bet against the housing market ahead of the financial crisis, saw a $3 billion loss in 2016, LCH estimated, reducing its accumulated net gain since inception to $18.4 billion and dropping it to No. 13 on the all-time list from No. 7 a year ago.
But it isn’t all doom and gloom. Sopher noted that while 2016 was a difficult year for all active managers, results improved sharply toward the end of the year. “This, combined with the continuing trend to lower fees, should improve the prospects for hedge-fund managers to generate strong, positive returns after fees for their investors,” he said.
Top hedge funds that use computers and quantitative models to trade financial markets have generated $113 billion in net gains over the years, making up a quarter of the total amount of net gains produced by the top 20 hedge funds in history.Indeed, the line between man and machine is blurring in the hedge fund world as technology, algorithmic trading, and an army of PhDs in math, astrophysics, computer science and data analytics are reshaping Wall Street and the hedge fund world.
That’s what LCH Investments’ annual survey of the top 20 hedge fund managers shows, which for the first time includes data from some hedge funds that use systems-based investment approaches.
According to LCH Investments, four of the top 20 hedge funds that have generated the highest amounts of net returns are highly reliant on algorithmic trading. Those hedge funds include billionaire Ray Dalio’s Bridgewater Associates, which has produced $49.4 billion in net gains since inception, more than any other hedge fund.
LCH has long included Bridgewater on its top 20 hedge fund managers list, but this year for the first time the list also includes three major hedge funds known for their computer and data-driven approaches to investing. DE Shaw, the quant firm founded by billionaire David Shaw, lands in the third spot with $25.3 billion in net gains. Billionaire Ken Griffin’s Citadel, which also uses systems-based approaches, is fifth with $25.2 billion in net gains. Two Sigma Investments, the quant firm run by billionaires John Overdeck and David Siegel, are in the 20th spot of top hedge funds with $13.1 billion in net gains.
In an interview Rick Sopher, chairman of fund of hedge funds LCH, said it has become impossible to ignore the impact that computer-driven investing is having in the hedge fund world and that many traditional hedge fund managers are now adopting some algorithmic methods. Hedge funds are increasingly using big data and machine learning in their quantitative trading.
To be sure, LCH’s hedge fund list understates the success and influence of the quants. For example, LCH was unable to get good enough data to include on its list billionaire James Simons’ Renaissance Technologies, the top quantitative hedge fund ever, which no doubt has generated the kind of net gains that would place it near the top. But the bulk of Renaissance’s gains have been generated by the secretive Medallion fund, for which good data is hard to come by.
In addition some of the hedge funds that LCH does not include as funds that use systems-based approaches have sizeable quantitative businesses. For example, billionaire Israel Englander’s Millennium Management includes a $4 billion quantitative trading arm called WorldQuant. Other firms on the list, like billionaire Paul Tudor Jones’ hedge fund, are ramping up their computer and data capabilities to compete. The line between man and machine are blurring in the hedge fund world.
“The increasing capabilities of technology based investment systems is in evidence,” Sopher said in a statement. “The new entrants in the top 20 are all investment firms which depend partly or wholly on such approaches, reflecting this powerful and continuing trend in money management.”
But before we start hailing the quants as the new kings of the hedge fund world, I would take a step back and be a lot more skeptical. In particular, as more and more money flows into these quant hedge funds, have they been able to deliver consistent results?
I'm highly skeptical and from my vantage point, I'm seeing elite hedge funds shafting clients on fees, charging them pass-through fees to pay for all these technological upgrades and other expenses, claiming it's in the clients' best interests but when you look at overall results and add the excessive fees they're charging for these algorithmic approaches, you've got to wonder where's the beef?
Also, it's worth noting quants have been doing well since 2009 in a market environment where assets are increasingly being diverted into ETFs -- the big beta bubble -- and volatility has been coming down gradually as all these ETF issuers hedge by buying VIX futures from speculators selling them to earn a steady yield, something which was covered last August in this Reuters article, Focus on VIX futures shorts hides the real story:
Judging by the way hedge funds have been betting on Wall Street, they see U.S. stock market volatility remaining low, but it may not be that simple.Why is this pertinent? Because it's important to understand market structure to dig a lot deeper before you blindly buy the iPath S&P 500 VIX ST Futures ETN (VXX) thinking it's headed right back up. The long-term chart suggests a lot of speculators going long volatility got burned in the last few years (click on image):
CBOE Volatility Index (VIX) futures contracts allow a play on implied volatility in stock prices and can provide a hedge on equity returns, but big speculators are currently net short 114,088 contracts in VIX futures, just under the record level set earlier this month, according to U.S. Commodity Futures Trading Commission positioning data through August 16.
After trading in a range for most of the past year, U.S. stock prices recently broke out to record highs and hedge funds have reluctantly bought into the rally. Their net long/short exposure has increased to 22.8 percent, a top quartile level, but still shy of the 5-year peak of 24.5 percent set last December, according to Credit Suisse data.
On the face of it, the CFTC data could be seen as evidence that speculators strongly believe in the lasting power of the recent rally in equities and expect the CBOE Volatility Index .VIX, which is near historic lows, will remain subdued.
"That's not exactly right," said Maneesh Deshpande, head of equity derivatives strategy at Barclays.
Deshpande and other derivatives market experts say speculators are to a large extent just selling VIX futures to the issuers of exchange-traded products (ETPs) who need protection against volatility.
With the S&P 500 stock index .SPX near a record high, demand for these is quite strong.
For instance, money flows into the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the most heavily traded long volatility ETP, are the strongest in three years, according to data from Lipper. In turn, that's creating steady demand for VIX futures that the hedge funds are only too happy to supply.
"Strong inflows into long VIX ETPs means the issuers of these products have to go and buy VIX futures," Rocky Fishman, equity derivatives strategist at Deutsche Bank.
Even in the absence of those inflows, the way these ETP products work means that as market volatility declines it requires these product issuers to buy more VIX futures contracts.
It is in response to this strong demand for VIX futures that speculators have ramped up the selling of VIX futures. Essentially, these funds are acting as liquidity providers, not making outright bets.
What does the VIX have to do with quant trading strategies? Quite a lot. I remember a conversation with Ron Mock, Ontario Teachers' CEO, when he was running the hedge fund program where he told me "quants do well in a volatility range between 15-25 on the VIX" (if my memory serves me well). "When volatility falls below 15 or spikes above 25, quants don't do as well."
In other words, if volatility spikes over the next year, you would think all these quant hedge funds engaging in complicated algorithmic trading and clipping yield by selling options are going to get burned big time. It could get even worse as the big beta bubble implodes in the second half of the year as investors come to grips with the reflation chimera I warned of and Francois Trahan's bearish market call which he recently reiterated at a CFA Montreal luncheon.
On this topic of low vol, Joseph Ciolli of Bloomberg reports, Why Stock Market Volatility Isn't Really as Low as It Appears:
Correlation, it’s sometimes said, equals volatility. An index can’t swing very much unless a lot of its members are going the same way.
So if you’re wondering why the CBOE Volatility Index has been so quiet lately, that’s part of it, according to Dean Curnutt, chief executive officer at Macro Risk Advisers. Stocks are charting independent courses under Donald Trump, and it’s holding broad measures of turbulence down.
S&P 500 Index realized correlation now sits close to the lowest level on record, according to data compiled by Bloomberg. A five-point reduction in the correlation of stocks in an index translates to a one-point decline in the gauge’s volatility, according to Curnutt (click on chart).
“Since the election, certain sectors like financials and industrials have done well, while others have lagged, and they kind of cancel each other out, resulting in lower volatility,” said Matt Friedman, senior vice president of options trading at Convergex Group LLC, in New York. “Whereas when correlations are very high, you tend to see pullbacks in the market, which coincides with spikes in volatility. It’s all related.”If the VIX does spike up it could spell big trouble for many quant hedge funds. Of course, some analysts think everyone is getting it wrong on the fear index and there isn’t much historical data to support the idea that a low VIX is bearish:
The S&P 500 climbed 0.7 percent to 2,296.46 at 12:39 p.m. in New York, while the VIX slipped 7.9 percent, headed for its biggest decline in two weeks.
With equities hovering close to records, traders seem impervious to risk, even as new policies from President Donald Trump stir up discord. One-month realized volatility on the S&P 500 was 6.51 in January, only the fifth time since 1928 that a year has begun so calmly.
Despite lots of evidence the peace is related to improving economic expectations, the tranquility continues to strike some people as weird. One thing they cite is a measure of global policy uncertainty that has gotten more extended versus the fear gauge than at any point in the past two decades. The volatility index also sits at the lowest since the start of 2015 relative to expected price swings in the Chinese yuan-U.S. dollar cross (click on chart).
“We have a new president who’s completely unorthodox, yet the market’s not moving,” says Curnutt, whose firm is paid to arrange volatility trades. “It’s a challenging time for investors because they see all these risks, but the market is waving them off.”
MRA surveyed clients and found unwelcome political developments and unexpected Chinese currency debasement are what they’re mostly worried about.
Curnutt has been recommending clients consider short-term hedges at such low prices. While President Trump has spurred a rally in financials and industrials, investors should be prepared in the event that he doesn’t follow through, according to Curnutt. He also notes that the biggest VIX spikes of the past five years came on the heels of large moves in China’s yuan.
“The misrepresentation of the VIX as a fear gauge signaling future market weakness is just plain wrong,” Citi’s Tobias Levkovich said in a note to clients on Friday. “Widely available indicators provide little investment ‘edge’ even if the consensus narrative is overly focused on this volatility metric despite its poor predictive power. Indeed, the S&P 500 has been higher 84%-88% of the time 12 months later when VIX readings were between 10 and 20 or between 30 and 40; hence, low or high VIX levels are not nearly as useful as advertised.” (click on image)Whether or not the VIX spikes up, my advice to institutional investors is ALWAYS BE HIGHLY SKEPTICAL of all hedge funds, including elite, secretive quant hedge funds that think they have the holy algorithmic grail on markets all written up in a tidy mathematical computer code (I can just see Euler turning in his grave!).
For years, Levkovich has argued that the VIX is “wildly misunderstood.”
“Yet, there is a constant drumbeat about this ‘fear gauge’ that does not generate the kind of fearful declines that are being advertised,” Levkovich said. “In our minds, data trumps opinion…”
So, while a low VIX reflects a low premium for protection against market volatility, it does not necessarily reflect a bearish level of complacency. Rather, the opposite seems true.
I know, the king beast of quant hedge funds, Renaissance Technologies (RenTec), had another stellar year in 2016, making Jim Simons, Peter Brown, Robert Mercer and Donald Trump very happy:
Robert Mercer, the co-chief executive of Renaissance Technologies, played a big role helping Donald Trump win the White House last year, but his efforts did not distract the world’s most elite hedge fund firm from making profits in financial markets.Despite these political differences, it seems like RenTec is humming along, for now, but past success doesn't guarantee future success, not for Jim Simons or for George Soros who uncharacteristically lost a billion dollars last year after Trump was elected.
Renaissance Technologies’ biggest hedge fund, the $15 billion Renaissance Institutional Equities fund, was up 21.5% net of fees in 2016. Another large Renaissance hedge fund that consists of money from outside investors, Renaissance Institutional Diversified Alpha, was up 10.7% last year.
The good performance at Renaissance Technologies, which specializes in quantitative trading and models, comes amid general struggles in the rich hedge fund industry, where the average hedge fund manager, according to HFR, gained 5.6% in 2016. It was yet another year in which the hedge fund industry significantly trailed the return of the U.S. stock market. A new and relatively small Renaissance hedge fund, the Renaissance Institutional Diversified Global Equities fund, returned 1.7% last year.
Founded by billionaire James Simons, Renaissance Technologies has consistently outperformed the entire hedge fund world for decades, particularly with its secretive Medallion fund, which has for years been a proprietary strategy that has not been open to outside investors. Medallion reportedly posted returns of 21% in the first half of 2016, according to a Bloomberg News report. With the strong returns and new investor money rushing into the firm last year, Renaissance Technologies now manages about $36 billion.
But 2016 was not your average year at Renaissance. The secretive hedge fund firm based on New York’s Long Island attracted a lot of attention because of Mercer’s support for Trump. Mercer financially backed his daughter’s Trump super political action committee and Rebekah Mercer hopped on the Trump transition team’s executive committee. Mercer also has long-standing ties to two key members of the Trump Administration, Stephen Bannon and Kellyanne Conway.
Mercer’s political work has stood in sharp contract to Simons’ political activities. Simons has traditionally been a big supporter of Democratic candidates and backed Hillary Clinton’s White House run in a big way in 2016. Mercer’s co-CEO at Renaissance, Peter Brown, also leans Democratic—his wife, Margaret Hamburg, held positions in the Clinton and Obama administrations, including head of the Food & Drug Administration. Mercer and Brown have been co-CEOs at Renaissance since Simons retired a few years ago and their working relationship has produced excellent results for a long time.
Indeed, Simons’ biggest concern ultimately may be that the outside activities of his top executives not detract or hurt the incredible business he built. Renaissance Technologies has led the quantitative trading revolution that has swept Wall Street and at the moment that business seems to be humming.
But I wouldn't count Soros out just yet. In fact, I think he's going to do extremely well in the second half of the year as his bearish bets pay off "bigly".
I also found it interesting that he recently hired a woman, Dawn Fitzpatrick, a senior exec at the asset-management arm of UBS, to be his next CIO (click on image):
Soros didn't hire Ms. Fitzpatrick for her good looks or quantitative skills, he hired her because she's damn good at what she does, managing and allocating money:
A spokesman for Soros confirmed the hire. Bloomberg earlier reported the news.Soros is also sending a clear message to his testosterone-challenged peers that if the king of hedge funds isn't scared to hire a woman for his top investment position, maybe they too should open their minds and start diversifying their workforce at all levels of their organization.
Fitzpatrick replaces Ted Burdick, who left the position last fall but remained at the firm. While her start date is unclear, Fitzpatrick would be Soros' seventh CIO at Soros Fund Management since 2000.
At UBS, Fitzpatrick oversaw more than 500 billion Swiss francs across investment teams, according to her UBS bio. She previously was the head and CIO of a multibillion-dollar hedge fund owned by UBS. Fitzpatrick started her career in 1992 with O'Connor & Associates as a clerk on the American Stock Exchange.
I wish Fitzpatrick a lot of success in this coveted (high pressure) role that others can only dream of. I'm also wondering how Soros's former CIO and protege, Scott Bessent, is doing.
I haven't read anything new on Bessent but one person who had one-up on Soros last year is ex-Brevan Howard superstar trader Chris Rokos. He had a stellar year after launching his quantitative global macro fund. Bloomberg reports that Rokos’s hedge fund rose about 20 percent in 2016, its first full year of trading, to become one of the world’s best-performing money pools betting on economic trends.
He is now seeking to raise more than $2 billion for Rokos Capital Management and I wouldn't think twice about investing in his new fund. In my opinion, Rokos is already a hedge fund legend and when all is said and done, he will be part of this elite list of hedge fund managers (and I'm not just saying that because of his Greek Cypriot roots, this guy knows how to print money in all market environments).
What other less well-known quant hedge funds are taking over the world? Last January, Nathan Vardi of Forbes reported on The New Quant Hedge Fund Master:
On a recent rainy October evening, Peter Muller, 52, sits at a piano on the stage of Manhattan's City Winery, playing with the band from his third album, Two Truths and a Lie. In between songs about love, heartbreak and relationships, like his Bruce Hornsby-reminiscent "Kindred Soul," Muller describes the long, strange trip he has taken in and out of high finance.Is Peter Muller the next Jim Simons and PDT the next RenTec? Maybe but who cares?
The tieless suits in attendance, from places like Goldman Sachs and Blackstone, paid as much as $1,000 a ticket to raise nearly $55,000 for the Robin Hood Foundation. And while Muller tells them of his early discovery of music, the existential crisis of his 30s, buddies he left behind in California and his family, there is a sense that many in the room just want to be in the orbit of the hottest hedge fund manager on Wall Street today. "I know you all had your choice of hedge fund manager CD-release parties," quips Muller. "Thank you for choosing ours."
Pete Muller is the latest, greatest member of a growing band of hedge funds that use complex math and computer-automated algorithmic models to buy and sell stocks, futures and currencies based on statistical correlations and aberrations that can be found in the market. During 2015, when many hedge fund managers--from mighty activists like Bill Ackman to noted short-sellers like David Einhorn--lost money, Muller spun the market's volatility into gold. The largest fund of his three-year-old PDT Partners firm, which oversees $4.5 billion, was up 21.5% net of fees in the first 11 months of 2015.
"We knew that Pete has a magic touch," says J. Tomilson Hill, the billionaire who runs Blackstone's $70 billion hedge fund investment unit. "I happen to be a big fan of Cézanne, and Pete is in his own way as gifted as Cézanne was." Paul Tudor Jones, the billionaire hedge fund manager, adds: "He is up there with the best and brightest--bar none."
Indeed, Muller's fund is so coveted that even Wall Street's power elite are willing to effectively grovel to get in on PDT's action. Many hedge funds stipulate that limited partners remain "locked up," or prevented from redeeming funds, for a predetermined period, usually one year. PDT is the opposite. Its biggest investor, Blackstone, actually agreed to be locked up for no less than seven years--in return for Muller's assurance that he would not kick it out of his biggest fund for the same period of time. Others requested the same lockup restrictions--and were refused. Even more astonishing is Muller's 3% of assets under management fee, and performance fees that rise to 50% of profits for benchmark-beating performance, compared with the already maligned industry standard of 2-and-20.
"Our goal is to be the best quantitative investment firm on the planet, but not in terms of number of assets, in terms of quality of the products," says Muller in his first interview since opening his new firm. "To take money out of the market with as little risk as possible and build a place people who are smart are drawn to." Muller's niche formula has also let him take plenty of money out of the market personally: Forbes estimates that in the last three years alone he's made $200 million before taxes, including gains on his own capital.
It's mid-November 2015, the U.S. stock market has given back all of its gains, and hedge fund managers around the globe are wringing their hands in anticipation of sending out another batch of disappointing investor letters. Muller is sitting in his Manhattan office. He is wearing a gray sweatshirt and jeans and has a Zen-like calm. His research chief has just left his office after telling Muller about a promising finding that could lead to the improvement of one of PDT's main models. "When people buy or sell in a desperate or hurried fashion, it tends to be helpful to us," says Muller, who is otherwise tight-lipped about what has gone right this year.
There are two screens in Muller's office: a flat-panel display on his desk showing the movement of his hedge fund's positions and a much larger screen on the wall that displays a real-time high-definition stream of the surfing beach at the foot of his house just north of Santa Barbara, Calif. When he's at PDT's headquarters in New York City and the waves are big, Muller sometimes yearns to be hanging ten. Luckily this doesn't happen too often, because Muller spends two-thirds of his time at his California home, where responding to "surf's up" is a regular ritual.
Muller may not appear to be a workaholic like many other Wall Street titans, but he is obsessive about his algorithms and problem solving, and he can get lost in deep thoughts for hours, days. His fear of burnout is real--he already dropped out of Wall Street once in 1999--and diversions like music and surfing are almost a necessity.
Muller grew up in suburban Wayne, N.J. His father was an electrical engineer and his mother a psychiatrist. He was good at numbers and loved music. At Princeton he studied math and played in a jazz band. After graduating, he headed to northern California to play music for rhythmic gymnasts and, figuring he had to pay the bills, eventually went to work for BARRA, a pioneering research firm that catered to quantitative financial firms. In 1992 he joined Morgan Stanley in New York as a proprietary trader to see if he could use math and computers to trade himself. Some of his investment banking colleagues were skeptical about the new math guy in the office. He called his group Process Driven Trading, or PDT. "I wanted to win and prove myself," Muller says.
Nobody outside the bank knew it, but for a long time Muller was Morgan Stanley's supersecret weapon, making big contributions to its earnings each year, hidden in the firm's income statement under "principal transactions."
Muller was able to carve out his own quiet area at Morgan Stanley's Manhattan headquarters, where his team of math nerds could dress casually away from the bank's testosterone-fueled, high-octane trading hordes. Muller became intensely focused on figuring out patterns that could help him beat the market. It was thrilling and exhausting. He thought and talked about it all the time--couldn't even sit through a Broadway show without stressing over it. "He is really smart, but a lot of smart people get lost in theory," says Kim Elsesser, a computer programmer and mathematician from MIT, and Muller's first key hire. "He also has very high expectations of himself and other people."
As Muller gained success and autonomy at Morgan Stanley his behavior became somewhat erratic. He detached from the office at a second home in Westport, Conn. in part because the pressures of work were overwhelming. His mind became so overloaded with mathematical formulas that he could no longer play music. Crossword puzzles became an escapist obsession; he even created them for the New York Times. By 1999 Muller started to feel like he could no longer find happiness on Wall Street.
"I was out of balance personally," Muller says. He went on sabbatical, rediscovering his love of music partly by busking in New York subway stations and sojourning in far-off places like Bhutan. After returning in 2000 he spent the next several years essentially as an advisor to the fund he created, PDT. Muller today likens it to a kind of executive chairman position that left him time to do other things, such as practice yoga and produce two music albums with titles like Just One Lifetime. He also met his wife, Jillian.
The soul-searching lasted about seven years, and Muller says it sent his trading operation into a period of stagnation. Muller then rolled up his sleeves and came back full-time to PDT in 2006. Unfortunately his return just about coincided with the quant meltdown of 2007, when the precipitate drop in subprime mortgage securities triggered deep losses for many firms. Under pressure from Morgan Stanley, Muller was forced to liquidate part of his portfolio. "Morgan Stanley Star Is Among Those Battered; No Time for Music Now," the Wall Street Journal 's front page blared.
As with many on Wall Street, the financial crisis changed the game for Muller. He had produced the kind of returns that would have made him a billionaire had he been an independent hedge fund manager. But working for Morgan Stanley always appealed because he didn't have to worry about raising cash, appeasing clients or back-office details. It was plug and play. He couldn't invest his own money in PDT, but he was well-paid, receiving a cut of his unit's profits, and could singularly focus on solving market puzzles.
There was also the tricky issue of the intellectual property Muller developed but Morgan Stanley owned. But 2008 exposed the danger of being dependent on one client, namely Morgan Stanley. It also gave birth to the Volcker Rule, a piece of legislation designed to make it impossible for a proprietary trader like Muller to work at a bank like Morgan Stanley. Over the next few years Muller engaged in on-again, off-again negotiations with the Wall Street firm about their operating arrangement.
"We preferred to stay together, but as the Volcker Rule emerged it became clear that would not be permitted," says Jim Rosenthal, Morgan Stanley's chief operating officer, who led the last round of negotiations with Muller. "Sadly, this was a business that was a steady source of revenue and profitability and did not pose significant risks to the firm."
In the end Muller would manage Morgan Stanley money until the end of 2012 and control the intellectual property Morgan Stanley was no longer permitted to use. Under the terms of the deal Morgan Stanley would get a cut of the fee revenue of the new, independent PDT for an undisclosed period of time.
On New Year's eve 2012 Muller transferred all of his group's investment positions from Morgan Stanley to PDT Partners. It wasn't only the positions and intellectual property that came with him--so did every single member of his 80-person staff. Invigorated, Muller went to work, increasing his new business and nearly doubling his employees.
"It feels great to have your own place," says Muller from his office on the top floor
of a midtown Manhattan building formerly occupied by Random House. "I never felt like I had to have my name on the door, but I didn't own it before, and in hindsight I didn't recognize the psychological impact of that."
In order to make his mathletes more comfortable Muller has had special glass walls constructed that are slightly curved to deflect sound and maintain the quiet workplace needed for concentration. Outside those quiet areas there are Ping-Pong and foosball tables near the kitchen and meeting rooms with whiteboards covered with mathematical formulas. Employees never wear suits; they run book clubs and organize poker nights that Muller sometimes attends. (He has made a final table at the World Series of Poker.)
Not much is known about Muller's black box models. He traded using two different strategies at Morgan Stanley that have morphed into the two hedge funds he now runs. The PDT Partners Fund is a statistical arbitrage fund built on models that have never had a down year. The $3 billion fund was up 21.5% in the first 11 months of 2015, and given its high fees, its gross returns were running at about 40%. Since inception in 2013 PDT Partners Fund has produced annualized net returns of 18.5%. Another fund, $1.5 billion Mosaic, has a longer time horizon and had produced returns of 10.5% net of fees through November of last year and 8.5% annualized in three years. PDT also has a Fusion Fund, which allocates cash between PDT Partners and Mosaic.
Returns like that are beginning to rival the long-reigning king of quants, Renaissance Technologies, known for market-defying consistency and for producing a net worth of $14 billion for its professorial founder, James Simons. While Muller is not yet even a billionaire, some say he is the new Simons.
Like Renaissance PDT is a Ph.D. farm, with 35 researchers who spend most of their days developing trading algorithms. They are organized into five teams by the asset class and time horizons they work on. Some work on futures contracts with longer holding horizons while others toil with statistical arbitrage strategies that trade stocks over a medium time horizon of several weeks. Most efforts to come up with new models tend to start with two-week-long deep dives but can grow into research projects that last a year. PDT has one open problem today that its people have worked on for four years.
And while most Wall Street research analysts expect their best ideas to find their way into firm portfolios within weeks or months, PDT takes an academic approach to portfolio change. Researchers know that their models may not affect returns for two years or more. In fact, PDT is still using models today with concepts that were initially developed 15 years ago, but models do decay over time and need to evolve with the market. "We are more intent in building a group of Ferraris than a bunch of Toyotas," says Tushar Shah, research chief at PDT.
Finding the right minds for Muller's model-making is almost as hard as decoding statistical arbitrages hidden in markets. Big data and sheer computing power have become a driving force in PDT's business model. Like other quants, PDT routinely competes with tech firms for leading programmers and mathematicians. It is now hiring more computer engineers than mathematician-researchers. Experts in machine learning are in high demand, so poaching talent from the likes of Google and Microsoft has become popular of late.
It's not always the eye-popping first-year salaries of several hundreds of thousands of dollars that hook new Ph.D. recruits. PDT researcher John Sun, 30, was finishing up an MIT Ph.D. in electrical engineering and computer science when he got an e-mail from Eunice Baek, Muller's longtime partner who manages recruiting. Sun would frequently get these sorts of e-mails and ignore them, but this one pulled him in. It said people at PDT like Lord of the Rings, science fiction and board games such as Settlers of Catan.
Like most PDT job candidates, Sun was flown to New York for a 36-hour interview on the second Saturday of November at PDT headquarters, where Muller and his partners tried to determine if Sun had the smarts and was someone with whom they could spend a lot of time. The guts of the recruiting weekend include a modeling interview and then collaborative algorithmic-based problem-solving games in which candidates are separated into small teams that Muller watches closely. PDT has a 3.5% turnover rate, and while the hours are not grueling, the work is demanding--trying to solve stock market puzzles often ends in failure.
"I want their shower time because in the shower they are thinking about things that get them to solve the problems," says Muller.
While Muller is supersecretive about the details of his models even to limited partners, who seem to invest on faith--he is adamant that PDT does not engage in ultra-high-frequency trading. Ferreting out small market inefficiencies is core to PDT's strategy, and what is also clear is that, for Muller, the more trading going on in markets the better. "There is a limitation on how much volume we can trade naturally built into our systems," Muller says, adding he will almost certainly return some capital to his investors at the end of 2015, as he did in 2014. Trust in Muller's machines is paramount, and he rarely intervenes manually, even when jarring upheavals temporarily defy his model's predictions.
Spending seven months of the year with a surfboard at the ready or composing in front of a keyboard, instead of obsessively staring at a CNBC ticker, probably gives Muller's PDT an advantage. Instantaneous information and constant volatility are the new reality of global markets. Whether it is index investing or robo-advisors, the discipline and brainpower of machines are winning on Wall Street. The rise of the quants is just beginning. "It will get harder, but we are prepared, and as information becomes more widely available and computing power increases, the strength of our models will improve," Muller says. "Quantitative investing is the best way to manage money, period."
Again, take everything you read on these quant hedge fund brainiacs and their "PhD farms" with a shaker of salt. I don't even know what PDT's returns were last year as there is no article mentioning how they performed.
Lastly, I had a brief email exchange with Mark Wiseman, the former CEO of CPPIB now at BlackRock, concerning the trouble their quant hedge funds are experiencing. Mark responded: "the article is not particularly accurate-- although there are challenges."
I hope Mark's group and his army of PhDs work through those challenges. I quite enjoyed reading BlackRock CEO Larry Fink's memo sent to staff on these 'uneasy' times. Good message and well worth reading.
On that note, I leave you with a rare interview with Renaissance Technologies founder Jim Simons, the mathematician who cracked Wall Street. I quite enjoyed this interview and think it's worth watching for a lot of reasons, not just the discussion on quants on Wall Street.
Second, Renaissance Technologies' Medallion Fund, shrouded in secrecy and fueled by a combination of science and finance, has produced around $55 billion in profit for the company's employees over the past 28 years. Bloomberg's Joel Weber offers insight on the fund and the brains behind the billions on "Bloomberg Markets."
Third, RBC Capital Markets Managing Director and Equity Derivatives Strategist Amy Wu Silverman discusses volatility, political uncertainty, valuations and the VIX. She speaks on “Bloomberg Markets.”
Fourth, Nelson Saiers, who graduated from the University of Virginia in 1997 and earned his PhD in a branch of theoretical mathematics called algebraic topology and then moved to Wall Street to prop trade, is now turning trading algorithms into fine art. Smart man, he sees the light and is actually doing something far more worthwhile and socially useful with his time.
Lastly, I quite enjoyed this recent exchange between Fox's Tucker Carlson and Mark Blyth, Professor of Political Economy at Brown University. Listen to Blyth, he gets it.
In my humble opinion, Wall Street needs less quants and more deep thinkers and artists. Chew on that and please remember to kindly donate or subscribe to this blog on the top right-hand side under my picture. I thank all of you who have kindly shown your financial support to this blog, it's greatly appreciated.
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