Quant Hedge Funds: String Theory + Algorithms = Binders Full of Money?

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Quant Hedge FundsThis article was guest-written by Zeke Lee, a Stanford graduate, former management consultant, and former derivatives trader on Wall Street. He founded the GMATPill.com, a video-based GMAT prep course for ambitious MBA candidates, and recently launched the Practice Pill Platform for interactive questions on the web, as well as an iPad app for GMAT practice (iPhone and Android versions coming soon!).

Imagine that a hedge fund approaches you with an enticing proposition: they’ve earned average annual returns in excess of 35% over a 30-year period that saw multiple recessions, stock market crashes and other calamities… and they want you to invest in their new fund.

To put that number in perspective, a 35% average annual return means that $1,000 invested 30 years ago would be worth $8.1 million today.

So how much would you pay in management fees and carry for the “privilege” of investing in such a great fund?

The answer: 5 and 44.

Yes, Renaissance Technologies is well-known for charging a management fee of 5% and carry of 44%, way above the industry average of 2% and 20%… because they’re just that good.

And this scenario is not just in your imagination: their premier fund has actually delivered 35% average annual returns after fees over 30 years (good luck getting an invitation to invest, though).

It’s no coincidence that Renaissance is also a quant hedge fund – the type that employs a small army of mathematicians, physicists, statisticians, and PhD’s all with a singular purpose: make as much money as humanly possible.

Our interviewee today also works at a quant hedge fund, and while he can’t detail his specific trading strategies due to the secrecy of the industry, he will share with you a bunch of insights on the space, including:

  • How to make sense of the quant fund space and what types of positions may be available
  • What an average day in your life will be like at a quant fund
  • How much money you’ll make at the entry-level, and as you move up the ladder
  • What prerequisites you need to win interviews at a quant fund, and what kinds of questions you might get in a quant interview

Let’s get started with “quantifying” all of this…

Quantifying Quant Funds & Predicting Positions

Q: I know you don’t want to share too many details of your own story breaking into the industry, so let’s start with an industry overview instead. What is a “quant hedge fund” and what are the different categories of quant funds?

A: Essentially, it’s any fund that relies on statistical techniques and math modeling rather than fundamental analysis to make investments.

A value-oriented hedge fund might try to find companies that are undervalued based on qualitative and quantitative criteria, such as industry positioning, growth potential, and valuation multiples vs. peers in the industry.

A quant hedge fund, on the other hand, would say, “Here are 200 possible conditions that might result in the stock price of Company X rising. Let’s test the statistical significance of all those conditions and use them to predict the direction that the stock is headed in.”

You can divide the industry according to a few different criteria:

  • Mathematically Complex Assets: Mortgage-backed securities and many other fixed income securities and variations.
  • Less Mathematically Complex Assets: Equities and anything else where the effective yield can’t be stated with a formula.

The quants spend a lot of time calculating metrics like cash flow and arbitrage-free valuation with the first one; the second asset class is less complex, but funds will still use statistical techniques to predict price movements.

Then you can divide the strategies into high-frequency and low-frequency; the former requires strong IT infrastructure, while the latter demands strong math modeling.

Q: OK, so what do you mean by “math modeling” there? I’m assuming this is completely different from the traditional 3-statement modeling and valuation that bankers do?

A: Good quant hedge funds typically treat trading questions as “scientific questions”: for example, what is the probability that MSFT will increase tomorrow?

To answer this question, a fund would study the conditions that made MSFT rise vs. fall historically. They would quantify these conditions and test the statistical significance of their conclusions. Examples:

  • Over the past 10 years, whenever Company X stock rose by 10%, MSFT declined by 5%; there’s a 65% correlation between the two.
  • Over the past 5 years, whenever trading volume of MSFT exceeded Y, it increased by X% on average; there’s a 50% correlation between the two.
  • In the past year, whenever oil exceeded $Z per barrel, MSFT declined by X% on average; there’s a 70% correlation between the two.

So you think about conditions like these, determine the significance and correlations between all of them, and then come up with an overall model that tells you whether an asset such as a stock will increase or decrease in value.

Fundamental shops may go through similar procedures, but some of the conditions may not be quantifiable and they might not test for statistical significance.

 Q: So it’s definitely a different kind of modeling than what bankers do – almost like a series of predictive statistical experiments.

What exactly do high frequency funds trade on? And how are they structured?

A: Their strategy is typically a variant of the following: “I know that somebody else will buy X, so let’s buy X first and sell it to them at a higher price.”

Some high frequency funds build algorithms to detect large orders that are about to be executed and front-run them accordingly. So in contrast to low-frequency funds, the high-frequency ones focus more on predicting these types of orders in advance rather than testing for the statistical significance of conditions before trading.

In terms of structure, there are traditional high-frequency funds that work the same way as any other hedge fund or quant fund, but there are also firms that are like “hotels for hedge funds.”

In other words, the company has a number of small teams that operate independently of each other. These teams may or may not be trading the same assets or strategies, and the company and the team members split the revenue. Examples of such firms are Tudor, Millennium, SAC, and Tower.

Each smaller fund has its own PM, team, and track record, but they will follow certain guidelines put together by the parent fund.

Q: I see – so what about the internal structure at those places? Do people specialize or is it more of an ad hoc structure?

A: It depends on the firm – I don’t think you can generalize. At some places, each employee performs a specialized task and “plugs in” his output into a large, automated system. For example, some employees may forecast returns while others will model transaction costs.

Renaissance works a bit like that where the roles and responsibilities are very structured; Citadel is an example of a fund where it’s more ad hoc and people do whatever is most useful at the moment.

Q: Speaking of these specific funds, any thoughts on the big names in the industry and how they all differ from each other?

A: Honestly, most of these places guard information so closely that no one outside really knows what goes on; my comments above are all I know about how some of these funds work.

Big names include Citadel, Renaissance, SAC, Tudor, and Millennium; there’s a good thread on Quora that lists other top names here.

There are some notable spin-off firms such as Two Sigma as well.

Your Mission, If You Choose to Accept It…

Q: Can you tell us about the different roles at a quant hedge fund? For example, at a normal hedge fund you see the Portfolio Manager, Investment Analyst, and Trader roles. How does that structure differ at a quant fund?

A: Those roles still exist, but you see a few additional positions as well. At most quant funds, the 3 main categories of junior-level employees are:

  • Traders: Similar to what traders anywhere else do: they execute trades by finding willing buyers and sellers and sometimes also come up with ideas on their own; relationships with brokers are critical here. You see mostly former traders from bulge bracket banks and occasionally from other hedge funds here.
  • Quants: They build tools to help traders assess potential rewards and risks of trades, or they try to predict asset returns. This is where you see the small army of statisticians, physicists, and mathematicians.
  • Programmers: They develop data access and analytical tools; they have to understand not only the markets and trading strategies, but also how all the software and hardware works, and they must write clean, extensible, and robust code because the software changes all the time.

So, essentially you have 5 roles at quant hedge funds: Portfolio Manager, Investment Analyst, Trader, Quant, and Programmer.

Q: Awesome, thanks for explaining that. With the trend toward quant / “black box” systems, is the role of the trader becoming less important? Do you think they’ll still exist in the long-term?

A: The importance of a human trader increases as assets that people trade become more complex. It decreases as more information becomes quantifiable and people better understand how to price and predict these assets.

So far, the second trend is winning. But there is probably some fundamental lower bound on the importance of traders, because there will always be “un-quantifiable information.”

I think the outlook is probably slightly better for you if you’re interested in joining a quant fund in more of a quant or programmer role, but there will always be demand for top traders no matter how much certain funds switch over to “black box” systems.

A Day in the Life of a Quant

Q: Thanks for weighing in there. I know readers have asked a lot of questions on whether or not certain roles will still exist going forward.

So what’s it like to work at a quant fund? How are the hours? What’s a typical day like?

A: The hours vary; it’s probably around 45-65 hours per week on average depending on what’s going on in the market.

The total entry-level compensation is between $200K and $300K USD.

Compensation thereafter depends on the individual’s and firm’s performances. It could stay the same or potentially go up to the millions.

Q: I just want to pause for a minute so everyone can appreciate the sheer amount of cash you just mentioned: $200K – $300K USD for entry-level positions.

On the other hand, it’s about the same as what post-banking entry-level roles in PE and at normal hedge funds pay if you look at the data.

But going back to my actual question, what’s a typical day like for you in terms of schedule and work tasks?

A: Someone in a quant role at a hedge fund might complete the following tasks each day:

  • Idea Generation – They’ll read academic research, attend conferences and talk to each other to generate ideas; then they’ll gather data and write programs to test their ideas.
  • Turn Ideas Into Trades – They’ll build models to turn their ideas into trades and will monitor the performance and risk of their trades, tweaking their models as necessary.
  • Get Better Trades – They’ll talk to traders, dealers, brokers, and so on to get better trading terms, lower transaction fees, and other “concessions” that make it easier to trade profitably.
  • Fundraising and Interviewing – These tasks probably take up less time than the rest, but occasionally quants will help with speaking to new investors to raise money and with interviewing new candidates for open quant positions.

You don’t have much of a “set schedule” because it really depends on what’s going on in the market – it’s not quite as crazy as the wildly unpredictable investment banking hours, but I’ve definitely seen people here stay late and work weekends.

So the notion that “the hours will be better” is a bit of a myth, and it depends heavily on the type of fund you’re at and what your role is.

Quantifying the Quant Recruiting Process

Q: For readers who want to get into a quant hedge fund, how would you recommend that they start? Are internships important? Are PhD’s important? What prerequisites are there to get into a top quant fund?

A: My #1 recommendation is to develop a strong understanding of statistics and some programming skills.

Q: Right, I think everyone knows that those skills are required, but what about getting the interview in the first place?

A: There are basically 3 ways to get interviews at quant funds: go through on-campus recruiting (not many funds participate, even at top schools), get friends at hedge funds refer you, or go through headhunters.

It’s just like the networking process for any other role: there’s a certain amount of randomness and luck involved, and you have to grind it out until you start landing interviews.

One really important point here is that the “soft skills” they look for in banking interviews such as leadership experience, charisma, and so on don’t matter at all for most quant interviews.

They’ll ask you questions about past quantitative projects, math/stats questions, and brainteasers, but they don’t care what your “greatest weakness” is or what your “greatest challenge” as a leader was.

Any major or program that helps you develop your knowledge of statistics and programming is helpful: math, statistics, science, engineering, etc.

Master’s degrees are helpful, and PhD’s are required for some firms and roles.

So if you’re a college freshman and you’re sure that you want to go into quant finance, you should pick a major that develops rigorous thinking and communication skills and one where you’ll work with data and do some programming.

Your major may not matter much for investment banking, but it matters a lot here: math, statistics, and computer science are the best choices.

Q: So if you’re a number-crunching machine who can answer brainteasers in your sleep, but you hate talking to people or interacting with carbon-based life-forms, quant roles might be for you.

A: Haha, well, that’s the non-PC way to put it I suppose. I would point out that you still have to interact with your team and communicate your ideas even if you’re in a quant role that’s more technically intense.

So it’s not like you can just sit and hibernate in a cave and never talk to people.

The difference is that your job isn’t dependent on calling people, developing relationships, thinking quickly on your feet, and cutting deals as it would be in the senior levels of banking and PE.

Of course, this is also true of many other roles at hedge funds and asset management firms, so I’m not sure if it’s unique to quant funds or not.

Q: What if you follow the quant route but end up not getting a quant job? What “Plan B” options are there in case you don’t get into your dream hedge fund?

A: Work for technology companies or anywhere where data analysis is important – for example, insurance companies, credit card companies, or social networks that have lots of user-generated data.

Your goals should be to learn statistics very well, gain market knowledge, and make money in the process.

Interview Drill-Down

Q: You mentioned before how they don’t care too much about “fuzzy factors” in quant interviews. What types of questions can you expect, beyond the general categories of “lots of math and brainteaser questions”?

A: Interview questions for traders within quant shops test your understanding of market events and intuition for asset pricing models. For example, they might ask you what typically happens to the US mortgage market when treasury bonds rally.

Other likely questions include those based on probability, statistics, and optimization.

One really common probability question in quant interviews is the “Birthday Problem”: what is the probability that two people in a room of 20 have the same birthday?

Another common quant interview question is the Monty Hall problem: you’re at a game show and there are three doors. Behind one door is a gift, and there’s nothing behind the other two doors.

You randomly pick a door, and the show’s host, who knows where the gift is, picks another door and opens it, revealing that there’s nothing behind it.

At this point, you’re given a choice to stick with your original pick or switch to the other door. Should you switch?

Q: So these questions have clear, correct answers, even though they may be counter-intuitive.

The Monty Hall one is interesting because it is in your benefit to switch, even though some people just can’t understand intuitively why that’s the case.

A: Yeah, the questions tend to be mathematically complex or counter-intuitive, or both.

So you need to think out loud in front of your interviewer so they can get a sense of what’s going through your mind. They can also help steer you in the right direction. Simply sitting there thinking in silence won’t help.

The Grand Exit?

Q: That makes sense – you pretty much always want to do that with any sort of technical, math, or brainteaser question unless it’s a quick answer.

So are you planning to stick around at your fund or move onto greener pastures?

A: As with most other buy-side roles, there aren’t real “exit opportunities” here: you stay at your firm and move up the ladder, or you go off to start your own fund instead.

So far I’ve done well here and the next few years seem promising, so I’m going to stick around. Eventually, it would be nice to start my own quant shop and run the show.

Q: Right, string theory + algorithms can be a powerful combination, but once you mix in entrepreneurship with all of that you can do a lot better than mere “binders full of money.”

Thanks for taking the time to speak with us and best of luck!

A: Thanks. Same to you.

About the Author

is a Stanford graduate and former management consultant with Booz & Company and derivatives trader on Wall Street. He founded GMAT Pill, a top-rated online GMAT Prep course designed for busy working professionals who want to study less and score more.

The course is known for its efficient framework approach to GMAT questions and also has a complete mobile solution so you can study during your commute or lunch break -- perfect for the investment banker. GMAT Pill is offering a free download of "What's Inside GMAT Pill" and "Being: A Red Flag Word" to M&I readers.

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50 Comments to “Quant Hedge Funds: String Theory + Algorithms = Binders Full of Money?”

Comments

  1. EG says

    Hi, Great post!

    Two questions:

    1. I am wondering what programming languages are most desired among quant funds, and in financial roles in general.

    2. How much weight does programming knowledge give to your resume? (if you don’t have much finance experience)

    Thanks!
    EG

    • says

      Thanks! I’ll attempt to answer your questions, though I’m definitely not an expert here:

      1. Specific languages don’t matter that much for most programming roles because they assume you can pick up anything if you’re smart and good at programming. Not sure which one is preferred for quant roles, but I believe you’ll see C/C++, Java, and C# and maybe more.

      2. It helps a lot for quant and programming roles, but less for pure trading roles I believe (though it may help there as well).

      • L says

        Matlab is very important (or R), and recently I was asked about Python. And you can think of practically anything even obscure and weird ones like K, F#, Haskell, Root and so on. Most of these places are very intellectually driven so they will expect you to pick up any new knowledge fairly quickly and enthusiastically.

        Probably you should be familiar with databases as well. The teams are usually small and work in isolation so top down approach is required. You are going to do everything from data cleaning to trade execution.

        If you love Maths this is a place for you.

  2. Allen says

    For those who are good with math (unlike me!):

    What would $1000 today look like in 30 years with a 35% average annual return IF you had a 5% management fee and 44% carry siphoned off that every year?

    Also, what’s the general formula to work such a sum out (i.e. work out how much money a hedge fund really returned to you, the investor)?

    • Middle Office Analyst at Manulife says

      Math Major here,
      Assuming 5% annual fee of the annual fund value every year and 44% of the fund return going to the fund, 35% return, after you give 44% to the fund, you’re left with 35%*44%=19.6%

      Time 0 = 1000*0.95 = 950 after the fee, 950*1.196 = 1079.39
      Time 1 = 1079.36*.95 = 1025.42 after the fee, 1025.42*1.196 = 1226.40

      Time 30 = 38540.06*.95 = 36613.06 after the fee, 36613.06*1.196 = 43789.21

      It’s easy to set up an Excel spreadsheet, the final annual return will be 13.62%

    • says

      What he said. :) But that 35% average annual return is actually AFTER management fee and carry, believe it or not. The intro confused that point a bit.

      13.62% is still a great return for not actively managing anything, though.

      • Middle Office Analyst at Manulife says

        Wow, that would make it approximately a 75% annual return before any fees. That’s insane!

      • Allen says

        Yeah, damn, that’s ridiculous.

        I thought I was gonna find out that because they charge 5 and 44 the return’s not all that great. 13.62% is decent but over the past 30 years (excluding the most recent 5), I feel that it’s something quite a few moderately-intelligent investment professionals could have done with a a little luck on their side.

        But 35% after those ridiculous fees??!! Holy S#@!

    • Anonymous says

      Note that Renaissance’s Medallion fund is generating those returns *after* fees. Their actual return is like 80%, which is how the senior people are so loaded.

  3. Co says

    Are quant hedge funds a possible exit after banking or do they look at bankers as not having the hardcore mathematical skills? Is it possible if you do have the math skills?

    • says

      While it’s not common, it’s certainly possible to get an interview with a quant fund post banking.

      Most recruiters who focus on quant fund recruiting actually scan candidates for perfect/high SAT scores or even GMAT scores – regardless of your previous experience.

      As long as you are a highly quantitative and intellectual type of candidate, recruiters will try to put you in for interviews.

      Of course, it’s usually better to follow the Master’s / PhD route if you are shooting for quant funds.

  4. Gabriel says

    Great post again guys. You should have gotten the interviewee for his reply to the attacks made on just about everything quant related. From Nassin Talebs Black Swan to Deidre Mccloskey saying that statistical significance was dead, etc… RenTech also seems like an anomaly, the only quant fund I’ve read about that hasn’t blown up in the long run…

  5. Richard says

    Great article!

    I just wanted to comment on the Monty Hall problem, that it doesnt matter if you switch. There is a 50/50 chance.
    Your previous selection does not affect yor future outcome.

    Let’s see it this way… if you had 2 doors, one of them with a gift and nothing behind the other door.
    What are your chances of winning the gift? 50 and 50 right? That’s undisputable.

    So you pick one door and they are about to reveal your result. There is still a 50% chance that you have picked the gift.

    Would it matter if they told you that there were 100 doors before, and it turns out that other person also picked the same door you just picked and these 2 doors are what is left of the 100 doors?
    No, you still have your 50%

    The other person HAD 1% of picking the gift and 99% of losing.

    So, whichever door you or he picks NOW, you still have 50/50.

    You might have the gift or not, there are 2 possible outcomes.

    In the same way, the other person that had previously selected the same door that you just did, he now has 50/50, regarless of how many times they had offered him to switch before (out of the 100 doors.)

      • Varun says

        I know about the Monty Hall problem from the movie “21″. And there they tell us to switch. Hollywood can’t possibly be wrong.
        Haha :D

    • Damien says

      If there are 100 doors, the probability of picking the wrong door initially is 99%. Thus, if the host open 98 empty doors, switching would move your probability of picking the right door from 1% to 99%, as the probability of picking the wrong door initially, is 99%

    • Eli says

      The host will only eliminate a door that doesn’t have the gift.

      The only way that you will lose by switching is if you initially pick the door which has the gift behind it. What’s the chance of that? If you have 3 doors, it’s 1/3. The events are mutually exclusive. So if you have a 1/3 chance of picking the door with the gift initially, you have a 1/3 chance of losing if you switch. Thus, you have a 2/3 chance of winning if you switch.

  6. Jason says

    There are some problems with this type of trading strategy. Statistical approaches rely on historical data, but analysts have no guarantee that past correlation values will continue in the future. There are also type I and type II errors. As a result, it would be interesting to know how much leverage these quant hedge funds, such as Renaissance, use. Let’s hope it’s not near the level of LTCM.

    • says

      The interviewee could not go into details on those types of specifics. From what I understand, Renaissance has very restrictive non-compete and confidentiality agreements, so even former employees haven’t disclosed much of anything after leaving and no one really knows the specifics of their strategies.

    • says

      “Front running” refers to a broker taking advantage of the fact that he knows a customer is about to place an order.

      What is described here is different because the fund doesn’t have customers placing orders with them as a broker would (he should have used a different word to describe it above).

      Instead, it tries to *predict* who will be placing orders based on what’s happening in the market.

      And these other orders are coming mostly from other large funds and institutional investors, as opposed to retail investors.

  7. Undergrad says

    So would a major in applied math/economics be less desirable to a quant fund than let’s say a computer science/statistics major? Or are all math majors looked at more or less the same, just the work tends to be more stat-heavy? Also I’m guessing that a Master’s at the very least is mandatory to be recruited as a quant?

    • says

      A major in applied math is ok but for economics, you would need to demonstrate heavy use of statistics (econometrics?) and programming. Either way, most quant funds will wait for hires who have advanced degrees, at least master’s degree or PhD degree.

      That said, it’s not unheard of for graduates with a bachelor’s degree to get an interview at these megafunds. It’s possible but passing the interview is rigorous and demonstrated practice of “hard core” quant is more common with advanced degree candidates.

    • says

      Not sure on that one, but I believe at banks the roles would be more structured / have a tighter pay range whereas they would be less structured and pay would be more variable at a fund.

  8. hbk says

    Great article. Regarding the trader role, you said

    “Similar to what traders anywhere else do: they execute trades by finding willing buyers and sellers and sometimes also come up with ideas on their own.”

    1. Is it pretty common for traders to come up with their own ideas in a Quant Hedge Fund?

    2. If not, how can a trader start his own fund (where he will likely be the Portfolio manager, making his own investment decisions)?

    Cheers!

  9. hbk says

    Also, regarding black-box trading (= algo trading?), you said

    “The importance of a human trader increases as assets that people trade become more complex. It decreases as more information becomes quantifiable and people better understand how to price and predict these assets.”

    1. What are some “complex” assets where human traders are still important?

    2. Similarly, what are some “less complex” assets where human traders are being replaced by machines/algorithms to a large extent?

    Thanks.

  10. Ben says

    Brian,
    Great website. I use it all the time and I purchased your interview guide. I am currently an applied mathematics sophomore at Georgia tech and I am really wanting to go into quant hedge funds. I am interning at a wealth management firm over the summer, but I want to know what I can do before I graduate to more easily get a full time spot in buy side ideally hedge funds.
    Thanks,
    Ben

    • says

      Biggest thing is to network extensively, come in with great stock pitch / trade ideas, and get an internship at a fund that uses a highly relevant strategy… but it will be really tough regardless to start there out of undergrad.

  11. Jerry says

    This is an awesome post, wish I came upon it earlier! I am currently doing a masters in statistics at stanford university, would you know how I can obtain interviews for quant funds? also, would a masters in statistics be enough to get my foot in the door or should I aim for a PHD? Thanks!

    • M&I - Nicole says

      I think a masters is fine. Some funds require a PhD though I think quite a few positions recruit Masters students. I’d start applying to funds as well as apply for your PhD as a backup.

    • says

      Veer,

      The language doesn’t matter so much as the fact that you can handle quantitative concepts.

      The idea is that if you have a strong grasp of any single language, you can easily pick up whatever custom languages that particular quant department uses.

      So foundational knowledge is more important than specific languages.

  12. Kristian says

    Hello Brian,
    Thank you for the informative post. I am currently an undergraduate senior majoring in math and finance. I am interested in working as a quant analyst for a low-frequency quant hedge fund. Currently I am contemplating on applying for a PhD. My question is what kind of a PhD would be most applicable for this role. I am not good at computer science, so I am thinking of either choosing statistics, mathematics or engineering. Furthermore, within these fields is there a more desirable path than others: for instance, applied math over pure math, or operations research over statistics, or financial math over financial engineering. Thank you so much for the help.
    Best of luck,
    Kristian

  13. Alex says

    I was wondering what types of math are needed in quant roles? is it advanced calculus and algebra, or is it more raw statistical evaluations and probabilities?

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