Home > finance, hedge funds, rant > The Life Cycle of a Hedge Fund

The Life Cycle of a Hedge Fund

August 10, 2011

When people tell me they are interested in working at a hedge fund, I always tell them a few things. First I talk about the atmosphere and culture, to make sure they would feel comfortable with it. Then I talk to them about which hedge fund they’re thinking about, because I think it makes a huge difference, especially how old a hedge fund is.

Here’s the way I explain it. When a hedge fund is new, a baby, it either works or it doesn’t. If it doesn’t, you never even hear about it, a kind of survivorship bias. So the ones you hear about work well, and their founders do extremely well for themselves.

Then the hedge fund hires a bunch of people, and this first round of people also does well, and they start filling up the ranks of MD’s (managing directors). Maybe at this point you’d say the hedge fund is an adolescent. Once you have a bunch of MD’s that are rich and smart, though, they become pretty protective of the pot of money they generate each year, especially if the pot isn’t as big as it once was, because of competition from other hedge funds.

However, this doesn’t always mean they stop hiring. In fact, they often hire people at this stage, young, smart, incredibly hard working people, who are generally screwed in the sense that they have very little chance of being successful or ever becoming MD. This is what I’d term an adult hedge fund. They have complicated rules which make sense for the existing MD’s but which keep new people from ever succeeding.

For example, when you get to a hedge fund, you start being assigned models to work on. You learn the techniques and follow the rules of the hedge fund, like making sure you don’t bet on the market, etc. If your model starts to look promising, they make sure you are not “remaking” an existing model that is currently being used. That is to say, they make sure, either by telling you what to do or asking you to do it yourself, that your bets are essentially orthogonal (in a statistical sense) to the current models. This often has the effect of removing the signal that your model had, or at least removing enough of it that your model no longer is statistically significant to go into production.

In other words, if the existing models are a relatively large collection, that perhaps spans the space of “current models that seem to work in the way we measure models” (I know this is a vague concept but I do think it means something), then you are kind of up shit’s creek to find a new model. By contrast, if you happened to start at a young hedge fund, or start your own hedge fund, then your model couldn’t be redundant, since there wouldn’t be anything to compete with it.

The older hedge funds have lots of working models, so there are lots of ways for your new, good-looking model to be swatted down before it has a chance to make money. And the way things work, you don’t ever get credit for a model that would have worked if there had been fewer models in production. In fact you only get credit if you came up with a new model which made shit tons of money.

Which is to say, under this system, the founders and the guys brought in during the first round of hiring are the most likely to get credit. Even if an MD retires, their working models don’t die, since they are algorithmic and they still work. But the money they generate goes into the company-wide pot, which is to say mostly goes to MD’s. So the MD’s have no incentive to change the system.

It also has another consequence, which is that the people hired in the second or further rounds slowly realize that their models are perfectly good but unused, and that they’ll never get promoted. So they end up leaving and starting their own funds or joining young funds, just so they can run the same models. So another consequence of adult hedge funds is that they spawn their own competition.

The only way I know of for a hedge fund to avoid this aging process is to never hire anyone after the first round. Or maybe to hire very few people, slowly, as the MD’s retire and as the models stop working and you need new ones, to be sure that the people they hire have a chance to succeed.

Categories: finance, hedge funds, rant
  1. August 10, 2011 at 9:05 am

    Couldn’t the adult hedge funds stop “breeding” competition by using non-compete contracts?

    • August 10, 2011 at 9:59 am

      First of all, yes they do make people sign non-competes, but they really don’t work over state lines, nor do they last more than 2 years, and I also don’t think they always work at all, especially if someone just becomes a day trader. So in the end I think they are pretty helpless to stop this phenomenon. I guess the situation where the non-compete would work is if Firm A steals an entire team from Firm B; then Firm B can sue Firm A. This sometimes does happen, but I’m not even sure that it’s a clearcut case.

  2. August 10, 2011 at 9:11 am

    In a speech he gave at MIT last year, mathematician Jim Simons, one of the most successful hedge fund founders ever, described a very different model for compensating his employees than the one you describe above.

    “Have an open atmosphere. The best way to conduct research on a larger scale is to make sure everyone knows what everyone else is doing… The sooner the better – start talking to other people about what you’re doing. Because that’s what will stimulate things the fastest. No compartmentalization. We don’t have any little groups that say. this is our system and we run it we get paid because of it. We meet once a week – all the researchers meet once a week, any new idea gets brought up, discussed, vetted, and hopefully put into production. And people get paid based on the profits of the entire firm. You don’t get paid just on your work. You get paid based on the profits of the firm. So everyone gets paid based on the firm’s success.”

    His hedge fund is definitely in the “adult” category–in fact, it is one of the oldest hedge funds around, since he started it back in the late 1970s.

    http://mitworld.mit.edu/video/870

    http://www.businessinsider.com/jim-simons-renaissance-mit-speech-video

    • August 10, 2011 at 9:51 am

      Interestingly, RenTec is one of the firms I had in mind when I discussed never hiring anyone to prevent this effect. They are notorious for hiring very few people, although that may have changed recently due to people retiring. But yes, I think they are an exception to this rule one way or another.

  3. August 16, 2011 at 12:26 am

    Nice post, Cathy. Keep up the great work.

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