Quant Hedge Funds: String Theory +

Algorithms = Binders Full of Money?

by Zeke Lee
54 Comments | Hedge Funds & Asset Management - Groups
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This 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 videobased 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: theyve 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 theyre 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).
Its no coincidence that Renaissance is also a quant hedge fund the type that employs a small
army of mathematicians, physicists, statisticians, and PhDs 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 cant 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 youll 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

Lets get started with quantifying all of this

Quantifying Quant Funds & Predicting Positions
Q: I know you dont want to share too many details of your own story breaking into the
industry, so lets start with an industry overview instead. What is a quant hedge fund
and what are the different categories of quant funds?
A: Essentially, its 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. Lets 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 cant 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? Im 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%;
theres a 65% correlation between the two.

Over the past 5 years, whenever trading volume of MSFT exceeded Y, it increased by X%
on average; theres a 50% correlation between the two.

In the past year, whenever oil exceeded $Z per barrel, MSFT declined by X% on average;
theres 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 its 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 lets 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 dont 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 its 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; theres 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 theyll 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 youre 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 whats it like to work at a quant fund? How are the hours? Whats a typical day like?
A: The hours vary; its probably around 45-65 hours per week on average depending on whats
going on in the market.
The total entry-level compensation is between $200K and $300K USD.
Compensation thereafter depends on the individuals and firms 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, its 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, whats 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 Theyll read academic research, attend conferences and talk to each
other to generate ideas; then theyll gather data and write programs to test their ideas.

Turn Ideas Into Trades Theyll 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 Theyll 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 dont have much of a set schedule because it really depends on whats going on in the
market its not quite as crazy as the wildly unpredictable investment banking hours, but Ive
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 youre 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 PhDs 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.

Its just like the networking process for any other role: theres 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 dont matter at all for most quant interviews.
Theyll ask you questions about past quantitative projects, math/stats questions, and brainteasers,
but they dont 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.
Masters degrees are helpful, and PhDs are required for some firms and roles.
So if youre a college freshman and youre sure that you want to go into quant finance, you
should pick a major that develops rigorous thinking and communication skills and one where
youll 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 youre 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, thats 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 youre in a quant role thats more
technically intense.
So its not like you can just sit and hibernate in a cave and never talk to people.
The difference is that your job isnt 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
Im not sure if its 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 dont 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 dont 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: youre at a game show
and there are three doors. Behind one door is a gift, and theres nothing behind the other two
doors.
You randomly pick a door, and the shows host, who knows where the gift is, picks another door
and opens it, revealing that theres nothing behind it.
At this point, youre 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 counterintuitive.
The Monty Hall one is interesting because it is in your benefit to switch, even though some
people just cant understand intuitively why thats 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 whats going
through your mind. They can also help steer you in the right direction. Simply sitting there
thinking in silence wont 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 its 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 arent 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 Ive done well here and the next few years seem promising, so Im 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.
http://www.mergersandinquisitions.com/quant-hedge-funds/

EG
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 dont have
much finance experience)
Thanks!
EG
Reply

M&I - Brian
Thanks! Ill attempt to answer your questions, though Im definitely not an expert here:
1. Specific languages dont matter that much for most programming roles because they
assume you can pick up anything if youre smart and good at programming. Not sure
which one is preferred for quant roles, but I believe youll 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).