The Rise of Quantitative Hedge Funds

This past March, machines once again demonstrated their superiority as Google’s DeepMind AI battered the reigning (human) world champion at Go, making it the latest classical board game to fall to machine dominance. As the first self-driving cars hit the streets and Wall Street adapts to robo-advisors, a comparable divide grows among hedge funds. Quantitative strategies, also known as “Black Box” for the mystery surrounding their algorithms, have been growing in absolute and relative terms. They’ve also recently been outperforming human counterparts, attracting even more investor dollars. Market values controlled by machine-based algorithmic hedge fund strategies (quants) have more than tripled since 2009:

Quants have also grown relative to their hedge fund peers. They now control over 13% of total long market value for all hedge funds, where it was only 8% in 2011.

That’s why, in lieu of our normal list of trends wrapping up the most recent quarter, we’ve dedicated the entire piece to this one, distinct trend. Given the recent performance of these strategies relative to fundamental investors, this trend is likely to continue. Even fundamentally driven managers are taking a new quantitative look at things. Funds are investing heavily in technology and risk management tools, adding a “quant” element to augment their existing investment process. These quantitative methods help with timing, sizing, and risk management. Our own clients use in-depth Novus analytics to squeeze out more and more alpha—despite shrinking opportunities—by optimizing their processes.

A Word of Caution

Maybe a word of caution is in order before we go full quant. While we don’t know what might happen if self-driving cars malfunction, we do have a precedent for stocks when algorithms converge on sell signals. This happened to quants in 2007—a relative asset peak for the strategy, as can be seen in the charts above. In August of that year, all quant models seemed to go haywire, executing sell orders at the same time. (Some believe the quants predicted the 2008 crisis, albeit a bit early.) The hectic two weeks of selling wreaked havoc even on unsuspecting fundamental managers who just happened to overlap the quants. Today quants have surpassed 2007 peaks in assets and—even more importantly—daily volumes traded. If another August 2007 event occurs, it’s critical for investors to know which stocks will feel a technical down thrust—at quants’ current numbers and trading levels, 2007 will seem like a cakewalk.

Thankfully, we’ve analyzed this possibility using something we call overlap analysis. We took thirteen of the world’s most prominent quant funds (Renaissance, Citadel, AQR, and Two Sigma to name a few) and calculated the overlap of their portfolios from public holdings. While we do not know the workings of the Black Box algorithms, we can see the results of their trading. Just like other asset managers, the quants are required to file public disclosure forms – we tapped them to run this analysis.

It’s important to keep in mind the sheer size of these portfolios, as well as the extraordinary position counts for each. Many of these funds hold more stocks than the Russell 3000:

It turns out that quants are often attracted to the same stocks, as the overlap values are high.

The above matrix shows a set of overlapping position values of for each manager pair. A value of 20% for AQR and Citadel denotes that after considering all the stocks that both managers are invested in and tallying up the minimum position sizes for each overlapping pair, you get 20% as the sum.

Looking at these portfolio positions, we see a lot of similarity and a preference for liquid securities. Also, quants never hold large positions. A 1% position is large for a quant fund. Some of the most popular positons for our group of quants are below (Negative values indicate put option exposure from public holdings):

Of course, most valuable for hedge fund managers is to run overlap of their own portfolio against the quants. When coupling concepts such as your own position sizing and liquidity, things get interesting, and you may get the urge to buy some put options on otherwise innocuous names. What goes up must come down and right now, quants are definitely up.