Institutional Investor's Alpha Magazine - March 2008 - (Page 23) Cover Story Quant Investing The New By Nick Rockel Math F or a man whose flagship hedge fund is running on fumes, Marek Fludzinski couldn’t be calmer. The founder and CEO of New York– based Thales Fund Management has watched his firm’s assets plummet by more than $1 billion during the past year, as Thales, like most quantitative managers, has suffered as a result of the global credit crisis that began last summer. But Fludzinski, who has a Ph.D. in theoretical physics from Princeton University and was one of the first two dozen employees at famed quant shop D.E. Shaw Group, is on a mission that means far more to him than profit and loss. He believes science is the key to unlocking the inner workings of the markets, and he intends to devote significant resources to prove it. “I think there is a law tying everything together,” says Fludzinski, 52. Science, however, didn’t much help Fludzinski last summer, when the onset of the credit crunch shook Thales and other quantitative hedge funds. Many of these firms specialize in a computer-powered strategy called statistical arbitrage, which uses mathematical models to profit from tiny mispricings of stocks and other assets. But in early August their models faltered after a large manager decided to liquidate its equity portfolio, most likely to meet margin calls on its credit positions. Partly because their strategies are based on many of the same academic theories, quant firms like AQR Capital Management, Renaissance Technologies Corp., D.E. Shaw and Thales held some of the same positions and began racking up huge losses. Sucker punched by the market, the quants didn’t know whether to cash out or stay in. Fludzinski and his peers came off like a bunch of propeller heads who had naively tried to bend reality to their models. This isn’t the first time Fludzinski has run into trouble. In 2002, Thales fell about 10 percent, say investors, prompting some to flee. This go-around, in a more difficult market, Fludzinski found ways to stem the losses. “We had enough of a risk control program in place that we weren’t forced to liquidate for margin calls despite our leverage,” he says. “We had layers of option strategies on top of our stat arb strategies to protect them from this catastrophic risk.” Yet even those risk Smarting from last controls didn’t save Thales from finishing 2007 down summer’s huge losses, some 10 percent, according to investors, some of quantitative hedge whom pulled their money. funds are pressing into The fund, which despite its struggles has delivered new realms of science an annualized return of 10 percent since its 1999 in an effort to prosper inception, began this year during the continuing with just $400 million in assets. credit crisis. This calamity wasn’t supposed to befall the quants, who are among the brightest people working in finance. During the past several years, managers and investors have flocked to their strategies, drawn by the promise of outsize returns and undersize risks. The dean of the quants is James Simons, founder of Renaissance, a publicityshy firm based in East Setauket, New York. Renaissance’s $7.5 billion Medallion Fund has posted a 39 percent annualized return — after its hefty 5 percent management fee and 44 percent performance fee — since its 1988 inception. But even Simons, who has a Ph.D. in mathematics from the MARCH 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 23
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