Institutional Investor's Alpha Magazine - March 2008 - (Page 25) the investment world. D.E. Shaw had been founded two years earlier by former Columbia University computer science professor David Shaw, who came from Morgan Stanley, where he worked under renowned trader Nunzio Tartaglia. A onetime Jesuit with a Ph.D. in astrophysics, Tartaglia was an early proponent of pairs trading. He would find the stocks of two related companies — say, General Motors Corp. and Ford Motor Co. — whose prices had diverged from their historical relationship, and then buy the cheaper stock while shorting the overpriced one. In this precursor to statistical arbitrage, Shaw — who launched his firm with $28 million from Greenwich, Connecticut–based Paloma Partners Management Co. and New York’s Tisch family — saw the potential for computerized trading on a grand scale. When Fludzinski arrived at D.E. Shaw, the now 1,300-person firm had about 20 employees. He ran one of the fledgling shop’s four quantitative strategies and began developing an options market-making system that would be able to price options on the fly. Fludzinski, who was born in Stafford, England, and grew up in Buffalo, New York, remembers D.E. Shaw as being extremely secretive. Fludzinski quit D.E. Shaw in 1992 to build a statistical arbitrage system for Swiss Bank Corp. in New York. Two years later he opened Thales Financial Group, the predecessor of his current firm. Fludzinski named it after the ancient philosopher Thales of Miletus, who, in addition to introducing geometry to Greece, is known as one of the first people to corner a commodities market — in his case, olives, more than 2,500 years ago. For the first four years, Fludzinski was bankrolled entirely by Paloma. In January 1999 he struck out on his own and launched the Thales Fund with $50 million. By the end of 2001, Thales had grown to $1.4 billion, mostly from funds of hedge funds, which were attracted to its market-neutral strategy. But the firm’s 10 percent drop in 2002 prompted the funds of funds to leave as quickly as they had come in, shrinking assets to $500 million. Fludzinski set about refurbishing his battered franchise: “We hired people and expanded our research department — by digging into my own retained capital — and it paid off.” According to Fludzinski, quant shops generally fall into one of two main camps: those that strongly emphasize statistics and those that show more interest in fundamentals. He says he has always tried to find the middle ground. D.E. Shaw alumni like Fludzinski tend to be comfortable looking at such factors as price movement and volume, which may be statistically significant to performance but are not easily explainable by pure fundamental analysis. Goldman Sachs quants have typically fallen more in the fundamentals camp, going back to the mid-1980s, when the firm hired MIT finance professor Fischer Black, known best for the options-pricing model he devised with Scholes and Merton. More-recent recruits include Clifford Asness, the University of Chicago finance Ph.D. who headed up Goldman Sachs Asset Management’s quantitative research group in the mid-1990s before leaving in 1998 to start AQR. In late 1995, Asness and his team launched Goldman’s famed market-neutral Global Alpha fund, which had an annualized return of 74 percent its first two years. Quant investing has changed dramatically since the pairs trading of the 1980s. Today’s traders have to deal with many more potential combinations and relationships. One source of this added complexity is quick access to information, as market news spreads much faster than in the past. “Now statistical arbitrage is a much higher dimension of problem,” Flud zinski says. “It’s almost like a chess game.” Sanford Grossman, president and CEO of Greenwichbased quantitative hedge fund firm QFS Investment Management, notes that the quant connection with academia has led to the widespread sharing of ideas. “Instead of inventing things themselves from scratch, many firms are reading academic papers, talking with academics and coming up with — ANDREW LO, PROFESSOR, strategies that for some reason MIT SLOAN SCHOOL work in a long historical simulation,” says Grossman, who continued to teach finance at the University of Pennsylvania’s Wharton School for more than a decade after founding QFS in 1988. “And then they do it. They don’t really know why it works.” According to Grossman, that was part of the problem last summer. He is surprised that so few hedge funds protected themselves by purchasing options when they were cheap in late 2006 and early 2007. In his opinion, investors are largely to blame because they don’t reward managers for being conservative. “They penalize them because those firms are underperforming in the period before a crisis occurs,” says Grossman, whose firm manages about $3 billion in assets. “One thing that would help the system is if investors in funds become more cognizant of risk management strategies and how they are being implemented.” Options protection helped Thales avoid the really big losses suffered last year by several large quant funds, including Goldman’s Global Alpha, which fell more than 14 percent the week of August 7 and 28.5 percent for the month. (For the year Global Alpha was down 38 percent.) Still, many Thales investors fled. Fludzinski says the reduced capital base gives Thales an opportunity to focus on “lower capacity — but ultimately higher return — high-frequency strategies.” Statistical arbitrage funds like Thales employ strategies that play out over different timescales, ranging from minutes to months. Fludzinski says there’s a lot of action in the middle, where holding periods can range from a few days to a few weeks. At the long end, stock movements are driven largely by fundamental macroeconomic factors like “They’re all looking at their models and trying to get an understanding of which ones did worse and which ones did well.” MARCH 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 25
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