Hedge funds battered in quant arms race; Trend-following strategies sputter in volatile markets

June 11, 2013 5:53 pm

Hedge funds battered in quant arms race

By Sam Jones, Hedge Fund Correspondent

At the end of this month, a team of Cantabrigian hedge fund quants will attempt to wipe out rivals from Switzerland – in a computer game. Cantab Capital (assets under management: $6bn) will fight Zug’s Amplitude Capital in Battlefield 3. The gaming shoot out, part of an online league, is the smaller scale and lesser known version of two wars being fought between the biggest names in the quant hedge fund world. The other is more high stakes. A “quant” arms race, involving tens of billions of dollars, is on for big managers to find new markets and new models in which, and with which, to make money and outshine their rivals. Quant hedge funds have always been motivated to stay ahead of their peers, but in the past few years the struggle has intensified for good reason. So-called “trend-following” strategies – which have historically been at the core of what firms such as Man, Winton Capital, Cantab or BlueCrest Capital do – have sputtered since 2010, wrongfooted by range-bound, volatile prices in the futures contracts they trade linked to bonds and equities. Trend following does as it says: funds’ computers look for consistent moves in futures instruments and then follow them, up or down, until the trend reverses.According to Hedge Fund Research, the average CTA – the catch-all acronym for most quant trend followers – has made just 2.4 per cent since the beginning of 2009, having lost money in three of the past four years.

And while 2013 had looked as though it was shaping up to be a good year for CTAs, May proved a reminder of trend following’s fallibility as a trading strategy.

The sell-off in global bonds, triggered mid-month by investors’ concerns over talk of the Federal Reserve winding down its quantitative easing measures, hit them hard.

“A known weakness of CTAs is violent turning points in markets” says Sandy Rattray, chief executive of AHL, and the co-creator of the Vix volatility index. “In May you had these very broad, in relative terms, rate increases but they also happened very rapidly.”

AHL, BlueTrend and Cantab, all lost over 8 per cent for the month each as huge long positions in futures contracts linked to global bonds and rates fell in value. Others were hit hard too.

But May also highlighted some of the differences between the big trend-following quants, differences that the quant arms race is exacerbating.

Winton, the world’s biggest quant fund, lost only 2.4 per cent over the month. It is up 6 per cent so far this year.

“My view has always been that the raw trend-following strategy will become less efficacious over time as more money has come into it,” says David Harding, Winton’s founder, and the founder of AHL too, which he ran before leaving Man in 1996.

For Winton, the large flows from investors into CTA strategies – of which it has been a major beneficiary – have led it to push its funds into one particularly big new territory: equity markets.

The firm, which historically only traded futures contracts, now takes around a fifth of its daily “risk” in cash equities in an effort to stay ahead of the competition.

“We started our equity research about seven or eight years ago and it is only in the past two years that our equity business has become significant,” says Mr Harding. Winton’s computers now process around 25,000 equity prices daily.

AHL too, Winton’s big rival, has entered previously unchartered territories for CTAs.

Through its “Evolution” strategy, AHL’s quants have developed ways of automatically trading over-the-counter derivatives contracts linked to all manner of previously inaccessible markets: from power to credit indices via iron ore.

Evolution lost money in May – about 6 per cent according to Mr Rattray – but has still made a great deal more than AHL’s traditional trend-following models. It made 10 per cent in April and is up 6.5 per cent so far this year.

“We are diversifying the range of markets we are active in,” says Mr Rattray. “We view it as one of our key skills.”

Among the other, new areas that AHL is looking to develop new trading capabilities in are US mortgage-backed bonds.

Other CTAs have even developed trading models based on value.

“Rather than just trend following we have more exposure to global tactical asset allocation models and shorter-term trading programmes,” says Ewan Kirk, Cantab’s founder – a former Goldman Sachs partner and astrophysicist by training. “We are much more about systematic macro than just trend following.”

Last year, when the average CTA lost 2.5 per cent, Cantab made 15.3 per cent.

Not that trend following does not have its place. Mr Kirk, and all the other big quant firms, still see it as the bedrock of most of what they do. And losses like those in May, or even those of the past few years, still do not deter them.

“When you play snakes and ladders and you throw a one, you’re not exactly thrilled about having thrown a one,” notes Mr Kirk, “but you don’t get up and say ‘What the hell is wrong with this dice?’”