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5. Neil Chriss Hutchin Hill Capital Innovation is a tricky concept for Neil Chriss, founder and managing principal of New York–based multistrategy hedge fund firm Hutchin Hill Capital. A skilled quant who taught himself programming when he was 11, on a TRS-80 computer his older brother had gotten for his bar mitzvah, the 48-year-old Chriss looks at innovation as an out-of-the-money call option that can lead to outsize rewards but comes with certain risks for companies, regardless of their industry.
Chriss, who has a Ph.D. in mathematics from the University of Chicago, began his career in academia before moving to Wall Street in 1996 as an associate in the equity division at Morgan Stanley, creating algorithms for the firm’s program trading. Two years later he moved to the quantitative strategies group at Goldman Sachs Asset Management, shortly after Clifford Asness and his team had left to form AQR Capital Management. Chriss made the move to hedge funds in 2003, when he joined Steven Cohen’s SAC Capital Advisors.
Chriss launched his now-$4.1 billion fund in 2008 with $300 million in capital from Renaissance Technologies founder James Simons’ Meritage Fund. He may be reluctant to call what he has done innovative, but his approach to capital allocation and recruiting is fairly unique among multistrategy funds.
Institutional Investor’s Alpha: How did you end up moving from traditional asset management to hedge funds?
Chriss: At the beginning of 2000, I left Goldman Sachs Asset Management to launch a start-up. At the time, a lot of people wanted to do Internet start-ups, and I was no different. I had this idea to create an interdealer brokerage of derivatives, specifically FX and interest rate derivatives. It actually was a good idea. It’s the kind of thing that became very big later.
“It’s very hard to know what other people actually do, so it’s hard to compare and say whether or not what we do is innovative.” — Neil Chriss What was the name of the start-up?
ICor Brokerage. I hired a bunch of people, including someone I installed as CEO. I wanted to be the operating guy and not the face-front guy. But we also hired a lot of sales guys from interdealer brokers to sell what we had. We were a technology and markets company, and we had our technologists. I worked a lot on the technology. Like I said, I think it was definitely a good idea, but the timing was terrible because it would have taken a long time to make the idea work. We started right as the Nasdaq crashed and funding became scarce. Ultimately, we did a joint venture with Reuters and they acquired it. So at that point I was at a crossroad, as I wanted to do something else and get back into finance. As it turned out, Barry Schachter, who was the risk manager at SAC Capital at the time, told me that SAC was looking to hire someone to build and run a quant business.
Now, this was very interesting to me because the way I looked at it was this was something I could do. They wanted me to be in charge — hiring portfolio managers, conceiving of the overall strategy and overseeing the capital allocation and risk management. I thought, That’s really good, because I am good at identifying smart, talented people and am able to take a step back and look at the big picture of how these strategies work.
I also thought that it would be interesting to work at a nonquant firm doing quant. It appealed to me because I had been at previous places where everyone is a quant and everyone is sort of trying to one-up each other with tiny little differences in perspective and detail and everyone has a Ph.D. I thought this would be different.
When I met Steve Cohen, I really liked him and his approach to the business. We got along well, and it seemed like a great opportunity for me to build a business within SAC’s fund. The whole idea of hiring portfolio managers and putting them all together into a strategy was something I had never even heard of. Steve described his business as running an internal fund of funds where he was the center of it, and he said he wanted to do the same in quant. As soon as he explained it to me, I thought, This makes a lot of sense.
What was it like to work for Steve Cohen?
It was a good experience. Steve was extremely focused on performance and preservation of capital, and if you got that right, it went pretty well for you. The PMs we hired loved Steve and loved the environment. He was very encouraging, and he gave them a lot of confidence. And he delivered, too. Steve said he was going to build this [quant] business and put a lot of resources behind it. And he did, in terms of investing in the infrastructure, investing in the people. Everyone who joined benefited a great deal, as did SAC.
When I was there, I was basically left alone to build the quant business. It went very well, and this gave me a lot of confidence. In retrospect, we benefited from starting at a good time, just as quant was going through a four-year period of very strong performance. We were able to hire very strong people and put capital to work relatively quickly.
Reflecting on these things when I started Hutchin Hill, it was useful to differentiate, to try to understand, what parts of our success were due to luck and what parts were due to skill. Knowing where you were lucky or what components luck filtered into is critical for good decision making in this business. Because if you’re going to make good decisions about where you should focus your time, energy and capital, you don’t want to think that a lot of what you did was the product of tremendous skill and then discover it was in fact due to quite a bit of luck.
How do you differentiate between luck and skill?
In general, it’s not easy to do, but let me start with a concrete example. I started at SAC in 2003, following what had been a difficult year for statistical arbitrage strategies. Because of this, there were a lot of people I could hire, in part because they were dissatisfied with the way they had been treated, compensated and managed in that difficult year. Many of them found that their management had not differentiated well between their performance and what was a difficult time in the market. None of them were fired, but the experience made them want to look for a different home.
Anyway, I was able to hire high-quality portfolio managers in 2003 and 2004 and, to a lesser extent, in 2005. And, as often happens, because of the shakeout from 2002, the returns to our strategies were really good early on. But then as we moved into 2005 and 2006, it got harder both to hire and to generate returns. This is often what happens as capital starts to flow into an area. It was kind of like the year 2002 was way in the rearview mirror, and people were catching on that quant was now pretty good, and people were heavily allocating into quant again. It also got more competitive to hire people, as more people wanted to get into the game because the returns were so good.
This is when I started to develop the idea that the more types of strategies that you can develop and recruit for, the more you can smooth out trends in hiring. Sometimes everyone is hot on a particular type of strategy, and that’s precisely when it’s most difficult to make good hires and enter a strategy. At the same time, there are areas that have just recently done poorly or are temporarily less favored. This is often exactly the time you should be entering or growing that strategy, especially if you have long-term conviction in the area and are taking the long view. So I said, “Wow, this is a really good way to set up a business.”
I thought that this should be part of our overall multiyear approach to business development and capital allocation. In short, we shouldn’t be momentum-oriented in how we run our strategies. We shouldn’t be carried along by whatever was doing well. This would be a form of diversification we would actively seek. This was really the origin of the multistrategy business plan that became Hutchin Hill.
If you look at what you’ve done in building Hutchin Hill — and the people and the processes you’ve put in place — what do you see as innovative?
“Innovative” is a tough word for me. I mean, from 50,000 feet we look somewhat different and somewhat similar to other funds. We’re not the only beta-neutral fund. We’re not the only multimanager fund. It’s also very hard to know what other people actually do, so it’s hard to compare and say whether or not what we do is innovative.
There are many ways in which I suspect we are different from other funds. For one, we have far fewer portfolio managers than most multimanager funds. We believe we can make smarter bets on fewer numbers of people and have bigger bets and more-robust teams. We spend a lot of time recruiting and developing teams. We really get to know them and let them really get to know us. This gives us the confidence to have fewer risk takers and invest more resources with them and their teams. We will surely grow the number of teams and strategies we have over time. We might increase the number of PMs we have by 50 percent or even more, but I believe we will always have far fewer PM teams than other funds like ours. So that’s one thing.
I would also suspect that the kind of framework for capital allocation and drawdown management that we have — just the way we look at risk in terms of, say, allocation, leverage and diversification — is different, maybe even innovative in some ways. We take the view, and we did a lot of research on this, that it’s very hard to make consistently good decisions about what asset class to be in at any given time.
I’ve heard some people describe their capital allocation process as looking around and finding the best place to put capital today and then putting the capital there, where it’s going to produce the highest returns. This is a very appealing idea, but we find it difficult to find solid evidence that it can really work. We also find it very difficult to verify if it’s working, because you get so few data points. You don’t make a lot of these decisions over the life of a fund, so it’s difficult to know whether you were lucky or had some kind of edge.
But it’s easy to understand why you might take this approach, because it’s very easy at any given time to look around and see clearly what’s doing well at the moment. Now, the reality is, whatever is doing well today will keep doing well. In fact, that’s a clear and major finding of our research. There’s a lot of momentum in strategy performance. So it makes a lot of sense that people would identify what’s doing well and pile into it. That’s going to generate quite a bit of immediate gratification.
And this tends to be self-fulfilling and reinforcing. Capital flows to whatever’s hot, and this puts the wind at a strategy’s back. So things tend to be persistently good for stretches, and because of the way capital flows and the way things trade, if tech, for example, is doing well in January, it’s probably doing well in February, March and April.
So it’s very easy to begin to say, “Hey, we can look around and say: ‘Event is doing well or it’s not doing well. These sectors are sectors that are doing well. Quant is doing well.’” And then because that persists for some time, it’s very easy to believe that you have some sort of edge in this process. It kind of seduces you. The only problem is, what we’ve consistently found in our research and our experience over many, many years and cycles of good and bad markets is, the bigger they are, the harder they fall. So the more persistent a particular trend is, the stronger or more powerful its reversal will be. This happens almost without fail.
And the other thing is, there’s absolutely nothing we’ve identified in our research that would give a profitable signal as to when a strategy in favor will go out of favor — meaning there are weak signals, but weak signals tell you either way too early or way too late and are very costly. The truth is, in many cases the tide turns with no warning at all. Right up to the moment the trend ends, there’s capital flowing in and the strategy continues to look good. Then something happens that most people didn’t expect and even fewer expected would precipitate a big reversal. Take the China A-shares market this year. Was 50 percent up enough? Was 100 percent up enough? Was 150 percent up enough? It just kept going. Then it had this violent downturn.
So for us it’s very hard to operate on the basis of getting in and riding a trend where a strategy is hot. And if you do operate that way, you could end up giving back a lot more than you started with. So if you’re not allocating away — that is, rebalancing — you end up really destroying a lot of the good work you did.
Can you provide a little more detail on the capital allocation process?
Capital allocation is an important concept in our industry, and it’s used sometimes without carefully defining what it is that capital allocation is attempting to achieve. What are its objectives? For us it became easier to do capital allocation once we defined clearly what our goals were in allocating capital, beyond the obvious — to make good risk-adjusted returns.
By way of example, some people are looking to say, “Where’s the best place to put my capital right now?” And if they think they have an edge in deciding that and if they feel they can get that right, then everything is easier and their process will reflect that. If this year you decided health care was the right sector to go in for whatever reason, if you overallocated to health care, then it’s generally going to have been a good year so far.
Our goal at Hutchin Hill is quite the opposite. Our goal in capital allocation is to balance our risk across strategies we believe in. We do a lot of rebalancing and try to avoid inadvertently being long strategy momentum. We look to shift capital slowly so that we’re not exposed to recent trends that could reverse with no warning. Another important goal for us is to use our capital allocation and specifically our strategy sizing to avoid being in situations where a drawdown in a given strategy is going to be so big that we need to cut capital in that strategy to protect capital. We have found that for a strategy that has long-term positive alpha, this is always worse than having been smaller in the first place. Proper sizing that allows us to stay in good strategies is a key goal of capital allocation.
One other thing that goes into this is that we have to understand the strategy and believe that the PM is executing properly. This forces us to be paying attention to details of the market and how the PM is trading within the market; we need to size the strategy properly so we can withstand a drawdown and stick with it.
Are hedge fund investors open to innovation,or would they prefer their managersto continue to do what they’ve always done?
There’s a baseline among investors — and I think more generally among participants in financial markets — to be suspicious of too much change from a manager. So if a manager does one thing well and they announce they’re going to add to their portfolio and do something else, there are always going to be questions: “Why are you doing that when you are so good at what you already do? This is not what we hired you to do.” This is not entirely unreasonable, if you think about it. However, the problem is that over the long term it’s highly unlikely that a fund can survive and thrive in financial markets — which themselves are constantly evolving — without significant change.
I’ll tell you a funny story. In 2008, when I launched Hutchin Hill, I made it clear that we were launching with fundamental credit. At the time, I had never overseen fundamental long-short credit and there was no obvious reason why I would be good at that. But we had a credit PM and I thought he was good and I thought being in credit was where I wanted to be. But potential investors would say: “Oh, why don’t you just stick with quant? It was so successful at SAC. You don’t know anything about credit.”
I remember one meeting in Switzerland right before we launched. I was meeting with a large fund of funds and this guy asked me, “So you’re going to launch with a credit strategy?” Yes. “You have a Ph.D. in math?” Correct. “You’ve never done credit, am I correct?” Correct. Then he asked some questions about quant. And then, ten minutes later, shaking his head, “So you’ve never done credit, have you?” And so it went. How could I be proposing to do credit when I had a quant background? My view was that we understood what to do in credit, had done our homework, and it was the right place for us to start.
Now, three years later, in 2011 — when we had our first go at equities — investors and potential investors would say: “Hey, Neil, why don’t you stick to strategies you’re good at, like credit and quant? Why are you going after equities, which you don’t know anything about?” This was after we had three very strong years for Hutchin Hill in credit. So people naturally wanted us to stick with what we were good at.
The nervousness around change is not without justification. Most PMs — most money managers — don’t have a successful track record in moving into new areas. And it’s not surprising. It takes a tremendous amount of work and conviction to enter new areas. It has to be part of the culture of the firm. Time, effort and resources must be invested, and success does not always come. Change is a risky business, like trading itself.
It doesn’t sound like there are a lot of incentives to pursue innovation.
The incentives are there, but to go after change is not without its costs. All companies have a problem balancing the expenditure of time and effort on the new while looking after their core businesses. This means higher costs now for potentially bigger gains later. The point is, when you have something that’s valuable — an existing product that’s doing well, for example — investing a lot of time and effort in something new and innovative that might or might not be profitable one day is always going to be a problem. Do something new, be bold and inventive, but don’t dilute your current products, don’t spread yourself too thin. This is a problem in any industry. It’s not in any way limited to hedge funds.
By the way, this is all why when people do truly innovative things they tend to get seemingly outsize rewards after the fact. The true costs of pursuing innovation are much bigger than they seem after the fact. Innovation has always been this sort of out-of-the-money call option. If you look for successful innovation in any industry in the world, we would all like to see a lot more of it. And that’s because if you can do something that’s not innovative and get paid well for it, there are a lot of very easy arguments to make to not go after innovation. There are huge temptations and pressures from all sides not to expend time, energy and resources on new strategies, products or directions.
Industries in general evolve in big bursts of innovation. There are long periods of stasis punctuated by shorter periods when innovation becomes cheap, necessary or acceptable to pursue. New ideas and approaches become acceptable to invest in, attracting capital and talent. So most of the time there’s this natural resistance to change that keeps things locked in a narrow channel. And then pressure builds up, something happens — new regulations, new technologies, big events that change the way people collectively view risk — to both allow for and force big changes. Then you see not gradual change but sudden changes over a relatively short period of time — years, not decades.
