Hedge funds styles, strategies, and firms evolve over time. The behavior of a hedge fund today is not the same as yesterday. These behavior changes are not because a manager has changed his style but because the environment, the tools, the regulations, and the ideas surrounding finance are different.
Of course, many of the guiding principles for a hedge fund are the same. Value managers attempt to find cheap assets. Trend-followers attempt to find trends. The evolution is generated through changes in technology, the structure of markets, and the implementation of strategy ideas. Technology implementation allows for cutting costs, enhancing skill, and gaining scale. The structure of markets requires managers to evolve. New ideas and knowledge help generate or improve skills.
Managers who are not thinking how to adapt will see their returns deteriorate and ultimately fail. Technology not used is a lost opportunity or places a manager at a competitive disadvantage. Ideas not employed hampers skills. Avoiding adaption reduces opportunities and increases costs. Adaption is core to good hedge fund management, yet being adaptive to changes may not lead to higher returns. Competitors are doing the same thing. Adaption may be required just to stay even with other managers in the sector. Some structural changes may lead to lower returns.
We have discussed the evolution of trend-following in the past, (see The evolution of trend-following firms to alternative risk premiums and quant shops), but the current environment requires more thought about firm evolution. Limited crises over the last ten years and greater competition means trend-following has seen a more constrained opportunity set. Managers have to adapt to exploit or enhance these existing opportunities and prepare for changes as we move further away from the last crisis.
The evolution of trend-following has followed a set of three intersecting paths: technology, structure, and idea generation. These intersect because some ideas can only be implemented if the technology is available, and some technology can only be used if there is a structural environment that allowed implementation. Investors need to ask how firms are addressing these intersections.
Technological improvements from computing power have been especially relevant for quant strategies like trend-following. The computing power has been directed into four areas:
- The use of speed to test new strategies through back-testing – any idea is quickly testable.
- The low price for storage – any amount of data is easily stored and available for review.
- The ability to electronically trade and parse orders to reduce transaction costs.
- The ability to process operations and manage risk – process and overhead can be reduced and position knowledge is readily available.
Idea evolution has allowed for better return opportunities and risk management; however, the broad use of new ideas diminishes the marginal edge given to any one manager. The major ideas that have affected trend-following include:
- The risk management revolution including VaR modeling.
- The improvement of portfolio management including volatility targeting and equal risk contribution.
- The use of new statistical tools for teasing out time series behavior.
- The ability to engage in complex non-linear thinking like machine learning.
Structural changes have reshaped the set of opportunities for managers:
- The introduction of new derivatives markets – Trend-followers have more markets to trade than before.
- Changes regulation that allows new products – Regulation has allowed for new fund structures that change the investor base.
- Changes in policy affect price behavior – Changes in monetary policy has affected the behavior of rates, which impacts trends. Changes in capital regulation opens new markets.
- Changes in industrial structure – The concentration and behavior within industries affect price opportunities.
An assessment of how firms are dealing with change may provide answers on which firms will be able to come out on top in a changing investment world. Unfortunately, firm adaptation is not a guarantee for higher returns when we are in a competitive environment.