Innovation has played an important role in the hedge fund industry since onetime journalist Alfred Winslow Jones came up with the novel idea, more than 60 years ago, of combining two speculative investment tools — leverage and short-selling — to create a conservative strategy. A skilled statistician with a Ph.D. in sociology, Jones believed that a truly hedged long-short equity portfolio would shift the risk from the vagaries of the market to the stock-picking skills of the manager. Jones, who when he wasn’t managing money devoted much of his life to fighting poverty, also came up with the somewhat less novel concept of charging a 20 percent performance fee — a practice that traces its roots to ancient times, when Phoenician sailors kept one fifth of the profits from their voyages.
| Innovators Clifford Asness Leda Braga Alec Litowitz John Burbank III Neil Chriss |
During the 1970s and ’80s, a new generation of swashbuckling hedge fund managers, led by George Soros and Michael Steinhardt, devised their own set of innovations, expanding beyond equities into bonds, currencies and other asset classes to make big macroeconomic bets. They were followed by über-quants James Simons and David Shaw, whose firms use sophisticated computer programs to identify mispriced securities. Although pure quantitative strategies like those employed by Simons’ Renaissance Technologies and Shaw’s D.E. Shaw & Co. represent a small percentage of today’s $3 trillion in hedge fund assets, the technological changes that enable them — especially the enormous growth in data and the computing power to analyze it — have had an impact on almost every investment manager.
To explore the current state of innovation in the hedge fund industry, we reached out to five of today’s most talented and thoughtful managers: Clifford Asness, co-founder and managing principal of AQR Capital Management; Leda Braga, founder and CEO of Systematica Investments; Alec Litowitz, co-founder and CEO of Magnetar Capital; John Burbank III, founder, managing partner and CIO of Passport Capital; and Neil Chriss, founder and managing principal of Hutchin Hill Capital. We asked each of them to discuss how innovation has affected their firms, what they do to encourage it and what kinds of transformational changes are likely to shape hedge funds in the future. Some of their answers may surprise you.
Like hedge fund pioneers Jones, Simons and Shaw, three of the five managers we interviewed have doctorates: Asness (economics), Braga (mechanical engineering) and Chriss (mathematics). But the other two are no academic slouches. Burbank has an MBA from Stanford University, and Litowitz has a JD and an MBA from the University of Chicago.
Some of the most interesting discussions we had were about the relationship between hedge fund managers and their investors, and the impact that interaction has on innovation. Systematica’s Braga tells a funny story about going to see investors in the mid-2000s, when she was at BlueCrest Capital Management, to talk about her BlueTrend fund. Chriss shares an equally entertaining tale of his encounter with a Swiss fund-of-funds manager in 2008, when he launched Hutchin Hill. In both cases the investors were nervous about change. Today, however, investors have a very different perspective, Braga says: They expect hedge fund managers “to adapt and evolve and get better.”
AQR’s Asness, who specializes in amusing anecdotes and one-liners, sees some of the greatest innovations happening in the area of hedge fund fees — or what he likes to call paying a fair fee for the risk taken. “There is no better innovation than saying, ‘We’re going to charge you the fair amount,’” Asness says. His firm has developed a line of lower-fee products that offer hedge fund market returns from strategies like merger arbitrage and convertible arbitrage, in addition to its higher-fee, higher-octane hedge funds.
Magnetar’s Litowitz believes that fee structures will change as investors get a better understanding of the risks involved in different strategies and products. The former head of event-driven strategies at Citadel thinks that hedge fund managers may even be able to charge more than the traditional 2 percent management fee and 20 percent performance fee for real, skill-based alpha, or market outperformance, but that more-standard, less differentiated investment strategies will command lower fees.
Passport’s Burbank brings a unique perspective to innovation. A student of literature and history, he relies on his imagination to try to anticipate market moves before they happen. For Burbank, being based in San Francisco has been critical to his firm’s success because of the richness of human capital and technological innovation clustered there. He believes that innovation is “fundamentally misunderstood,” not just by investors but by people in general. He says the impact of the Internet on businesses’ revenue and production is only now starting to be felt and will surprise a lot of people. According to Burbank, hedge fund investors and managers will need to open their minds to the possibilities if they want to get better at innovating.
