A Survival Guide For The Coming Hedge Fund War

Hedge funds and CTAs have struggled in recent years due to rapid decline in the supply of dumb money. When the current transition period ends and new strategies are fully deployed, only those who are prepared for the coming war will survive.

Professional traders can only generate high absolute returns if there is a steady supply of dumb money in the form of retail traders using technical analysis, recreational traders and also other professionals that are not well equipped to compete in a zero-sum game.

After 2008 the supply of dumb retail money has dried up because of two major bear markets in a course of eight years, one that started in 2000 and another that started in 2008, during which most retail traders were ruined and some of them became passive investors. At the same time, not well equipped professionals were also ruined in the last two bear markets, especially those that used mainstream statistical arbitrage and other well-publicized trading strategies.

There is no way for someone to profit in the markets without someone losing. Although in recent years central banks have increased their participation in the markets offering the impression that they are willing to lose in order to provide profits to the market participants, it is not entirely clear whether at the end of the day these institutions will accept realized losses. Therefore, although markets have recently seen participants that appear to be willing to provide profits, we do not know whether in the longer-term these profits will vanish. At the same time, it has become so obvious central banks have manipulated markets that it is dangerous for them to continue in this mode due to the moral hazard effect.

If central banks stop providing free money as major market players willing to lose, then the only way for hedge funds to realize returns will be from within their own group. As a result, a hedge fund war will commence.

Below I summarize the hedge fund survival guide for the new environment and then I briefly discuss it.

Alpha Targets Alpha Strategies What to Avoid
Retail traders (remained)

Other hedge funds

Idiosyncratic

Low capacity strategies

Academic advice

Unguided quants 

Alpha targets

These are the targets that will provide the alpha. The population of retail traders and their purchasing power have decreased dramatically over the last 17 years. Therefore, the major source of alpha will be other funds that are not well equipped or positioned to profit.

Alpha strategies

Funds with high capacity strategies find it hard to compete in this new environment. Pedestrian strategies, such as those used by CTAs have generated less than 2.5% annually in the last 10 years. The new environment favors small hedge funds that use idiosyncratic alpha strategies. These are strategies that are either hard to replicate or do not scale well, or both, so that large hedge funds cannot use them.

The times when someone with a small trading office using a few indicators and a large marketing department to maintain inflows could generate alpha are gone forever. Since there is no barrier to entry, anyone can do that and the available alpha, if any, is distributed accordingly. Although some have a hard time understanding this because of either lack of skin-in-the-game or a wrong perception of markets, this is the case.

What to Avoid

The number one enemy to alpha is academic research. I keep writing about this since 2012 but few have paid attention. Trading was always a secretive activity. As soon as some hedge funds started bringing in professors to gain reputation, the decline was inevitable. Professors care more about tenure and recognition than anything else. As soon as the academic community was exposed to trading secrets, the flood of papers started. Many well-thought edges were exposed and many others are being exposed constantly in academic papers. The Efficient Market Hypothesis will turn into a self-fulfilling prophecy due to this phenomenon if academics manage to expose most edges in the markets in exchange for papers and tenure.

In addition, some academic advice is flawed. For example, some high profile academics have already convinced practitioners that the major source of problems in generating alpha is over-fitting when in fact it was over-fitting that generated the high returns of the CTAs in the 1980s and 1990s. Some over-fitted strategies have remained over-fitted to special market conditions for many years, as I have demonstrated in a paper. As a result, the schemes they propose to correct for over-fitting can generate Type II errors (missed discoveries) and deprive traders from using strategies that can work well for extended periods of time. This is because market regime changes are more important than over-fitting, or in other words, some over-fitted strategies perform very well if market conditions remain the same. In effect, academics have convinced many practitioners not to follow their instinct but get involved in futile mathematical exercises that have only academic value.

Hiring young quants out of school to operate a hedge fund may prove fatal. Most young quants do not have any experience of a major bear market and naturally overestimate the models they learned, usually applicable to other areas and not to trading. Unguided quants and hedge funds based on buzzwords, such as artificial intelligence, will be easy targets for robust idiosyncratic alpha strategies and the first victims in the coming hedge fund war. Young quants with programming knowledge are an essential part of hedge funds but for implementing, not developing strategies. Development must take into account experience and skin-in-the-game; otherwise we are talking about toys.

The coming hedge fund war will commence in the next few years. It will be brutal with many casualties.

If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY 

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