The Quants Must be Crazy

Date: Friday, June 5, 2009
Author: Roger Ehrenberg, Wall Street Pit

As a number of historically top-ranked long/short managers have decided get out of the LP game, there is another pocket - a quieter, more stealthy pocket - of the hedge fund universe that is heating up to bubble-like proportions: high frequency statistical arbitrage trading. Where long/short managers were once the kings of the hill, the AUM titans that could move markets with the mere awareness of their interest in a particular security, the secretive, underground, geeky uber-quant crowd is now being feted by top shops looking for talent. Hedge fund strategies rise and fall in favor in a cyclical manner, as “hot” strategies become over-crowded and returns get compressed, while those out-of-favor are fertile ground for some truly differentiated alpha generation. Then those shunned strategies attract new assets while the previously desirable lose assets. And so it goes…

Generally, such strategy shifts are a function of alpha opportunity: investors will generally tilt towards strategies that can generate the most alpha in the current environment, and since investment conditions oscillate strategy allocations oscillate as well. But there is a new factor weighing on investors’ minds (and pocketbooks) that is having a pronounced effect on strategy allocation: liquidity. Among the universe of hedge fund strategies, which is the one that has the best liquidity profile? High frequency stat arb.

With signal horizons measured in sub-seconds, minutes or sometimes hours, these strategies trade highly liquid instruments long and short and generally will end the trading day at or near flat. Money is made through rebate capture strategies, rapid-fire pairs trading and the like. They good high frequency books tend to have Sharpe Ratios that are multiples of those of long/short and relative value strategies, specifically because the volatility of these strategies is muted due to the microscopic holding period. But this gives rise to the big drawback of high frequency stat arb - massive capacity constraints. In general, these strategies don’t scale well, and as the frequency goes up (with “ultra high frequency” being the moniker for the most silicon-intensive, millisecond holding period strategies) the capacity tends to go down. Books of $10-$20 million are not uncommon, and it is hard to build an ultra high frequency book north of $100 million. This compares to the multiple billions that can be profitably run via a value-oriented long/short strategy, where much more concentrated positions and much longer holding periods rule the day. But in today’s environment, this is not what investors want. Long lockups and high volatility? Out. Short redemption periods and low volatility? In.

And investors are willing to grant much higher payout to such strategies, and for good reason. Gains are losses are realized daily, not weekly, monthly or yearly. The mismatch between strategy holding period and the payout of incentive compensation is the driver of the backlash by LPs towards many of the premier long/short funds, and it makes sense. If your strategy has a holding period that is 18-24 months, should incentive comp really be paid quarterly? There is no rational argument for why the industry has grown up this way, and my guess is that this feature will, over time, come to an end. Both the timing and level of incentive comp needs to be calibrated to holding period - when these finally come into line, there will be a true alignment of motives between GPs and LPs.

But back to the high frequency frenzy. Of course, there is no free lunch. The influx of capital into what is a fundamentally capacity constrained strategy will compress returns and strip the alpha out in short order. And unless these funds amp up leverage as they did in 2007/08 to try and keep returns constant while spreads were compressing (which is what contributed to the quant fund blow-up), capital will necessarily flow out and into strategies previously tossed to the side where alpha once again exists, e.g., long/short. This is simply the nature of things. But for the hedge fund industry to rebuild its asset base and develop a healthy relationship between managers and investors, the timing and level of fees has to match the strategy. A “one size fits all” approach is neither appropriate nor desirable. It’s high time the LPs asserted their power and the GPs grew a conscience to do the right thing for the industry.