Can small quant shops compete with the big dogs?
Traditional, fundamental human traders and portfolio managers are being challenged by technology to a greater extent than ever before. As a smaller percentage of the hedge fund industry uses purely discretionary methods and a greater percentage incorporates systematic trading and big data analytics, it’s likely that the best long-term career opportunities will be at firms specializing in quantitative trading strategies.
For the first time this year, three computer-based hedge funds elbowed their way onto the fund of hedge funds LCH Investments’ all-time top 20 list of the best performers – D.E. Shaw (third), Citadel (fifth) and Two Sigma (20th), which all implement systematic strategies executed by trading algorithms. LCH estimates that those three quant behemoths, plus Bridgewater’s partially systematic Pure Alpha Fund, have made their investors $90bn over the past decade.
Bill Libby, the head of electronic quant sales in the Americas at Goldman Sachs, serving as a moderator at the Battle of the Quants conference in New York, asked his panel: With such huge, successful quant hedge funds like those three and Renaissance Technologies, which reportedly manages in the ballpark of $70bn, can smaller quant teams, startup firms and emerging managers compete in a world where you need economies of scale?
“The headline is that, yes, all aspects of quant trading are becoming scale businesses, and it’s increasingly harder for new players to make their mark against entrenched competition, partially due to the nature of the business,” said Manoj Narang, the CEO and founder of MANA Partners, formerly a vice president specializing in statistical arbitrage strategies in fixed income and derivatives markets at Goldman. “It is a finite sum business, and the opportunity set doesn’t get larger just because new players want to enter – you have to extract a slice from an entrenched player, which makes it difficult.
“Just like you wouldn’t go head-on against Google or Apple in their core businesses, the best way to make your mark is to do something unique and new,” he said. “There are far more great ideas out there than there are people to execute them, and everything is obvious in hindsight when looking back at things that were successful years.”
Some of the large players have gotten so large that they bypass some profit-making opportunities because they don’t deem them to be significant enough to be worth their while, Narang noted. Well-positioned small fry can pounce on them.
While it’s difficult to gain traction and win over investors without a long track record of success, it is possible for new firms to find a niche and build a business around the trading algorithm or investment strategy that they’ve discovered.
“If a small fund actually has its own privileged algorithm that makes money and the strategy is competitive, the founder will give investors the better strategy to increase their capital, whereas big funds may not, and when changing positions they have a big impact on the market, while small funds are more flexible,” said Huadong “Henry” Pang, a quantitative research analyst and risk strategist at Global Sigma Group who previously worked at J.P. Morgan and EY.
“Big funds have more resources, so as a small fund, they could be better in some fields if they specialize, just focus on one thing and be the best,” he said.
The bottom line is that new entrants and modestly sized quant firms should avoid trying to beat the big dogs of the quant space at their own game and instead embrace their idiosyncrasies.
“There’s no sense in starting a firm to launch a traditional quant practice, because economies of scale are so difficult to achieve,” said Maximilian Roos, the CIO of Sixty Capital Advisors who previously worked at Bridgewater, Goldman and BCG. “That said, there is a lot of room for innovation for small quant funds that do different things.
“We focus on flows to and from ETFs with lower levels of liquidity, so smaller specialized funds like ours will be successful if they’re doing something unique,” he said.
Low trading volumes and low levels of volatility make it especially difficult on smaller quant funds, which still have to deal with high cost of doing business, Narang said, so it helps to diversify your revenue streams.
“We launched a fintech practice that leverages the same IP as our trading business, and we explicitly seek to monetize our technology via products and services providing research and data over multiple business lines, which helps us to reduce or manage the costs more effectively,” he said.
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