Long article from the New Yorker about the ex-Equity Derivatives head at BoA who was built a mechanical hedge fund simulator. Worthwhile read
Kat had worked in the financial markets for almost fifteen years, but what he learned about hedge-fund fees shocked him. An investor who puts a million dollars in a fund of funds whose value goes up ten per cent in twelve months would face deductions of about sixty thousand dollars on the gains he makes. "Who wants to pay that kind of money?" Kat asked the executive who was interviewing him. "You can't seriously expect there to be anything interesting left after somebody takes out three and thirty." The executive was nonplussed. "I don't know," he said. "But they pay it."
The executive's firm offered Kat a job as the head of research, but he turned it down. The following year, he began teaching finance at the University of Reading, and in 2003 he became a professor of risk management at Sir John Cass Business School, which is part of City University in London. He continued to think about hedge funds. "When I became an academic," I said, "That's the thing I want to investigate," he recalled recently. "Is it really possible to generate investment returns to the extent that you can take out three and thirty and still be left with something you can call superior?"
However, Kat remained skeptical. As he conducted his research on hedge funds, he became convinced that it might be possible to generate similar returns in a mechanical way and with much less effort. Two years ago, he and Palaro began to sketch out ideas for a software program that could mimic the returns of individual hedge funds by trading futures. "We may be able to do without expensive hedge-fund managers and all the hassle, including the due diligence, the lack of liquidity, the lack of transparency, the lack of capacity and the fear of style drift (”changes in a fund's strategy) which comes with investing in hedge funds," Kat and Palaro wrote in a working paper about the project which they published last year.
In the London financial community, word of FundCreator's abilities has spread rapidly. As of last week, Kat said, two institutional investors were paying to use it, and more than fifty were experimenting with it. Kat and Palaro charge their clients an annual fee of roughly a third of one per cent of the money they invest using the software ”less than a fifth of what most hedge funds charge. The cost of executing futures trades must be added on to FundCreator's management fees, but, unlike at hedge funds, investors keep all the gains they make. "Why would you pay the high fees that hedge funds charge if you are able to get the same risk characteristics, in a statistical sense, by using a dynamic futures-trading strategy?" Bas Peeters, the head of structured products at ING Investment Management, said to me. "FundCreator is potentially a very cost-efficient solution." Pete Eggleston, the head of quantitative solutions at the Royal Bank of Scotland, one of the biggest banks in Europe, said of FundCreator, "Such approaches may revolutionize the industry in terms of providing investors with access to lower-cost investment returns."
It is notoriously difficult to distinguish between genuine investment skill and random variation. But firms like Renaissance Technologies, Citadel Investment Group, and D. E. Shaw appear to generate consistently high returns and low volatility. Shaw's main equity fund has posted average annual returns, after fees, of twenty-one per cent since 1989; Renaissance has reportedly produced even higher returns. (Most of the top-performing hedge funds are closed to new investors.) Kat questioned whether such firms, which trade in huge volumes on a daily basis, ought to be categorized as hedge funds at all. "Basically, they are the largest market-making firms in the world, but they call themselves hedge funds because it sells better," Kat said. "The average horizon on a trade for these guys is something like five seconds. They earn the spread. It's very smart, but their skill is in technology. It's in sucking up tick-by-tick data, processing all those data, and converting them into second-by-second positions in thousands of spreads worldwide. Its just algorithmic market-making."
Almost by definition, there can be only a handful of genius investors, Kat continued. "And even if they are there, the chances that you will find them and that they will let you in are very, very slim," he said. "That's what I tell people. If you are really convinced that you can find those super managers, then don't waste your time with our stuff. Go look for them. But if you are a bit more realistic, if you know that eighty per cent of hedge-fund managers aren't worth the fees they charge, then the rational thing to do is to give up trying to find a super manager, and just go for a good, efficient diversifier instead."