A New Theatre In the ‘War For Talent’

Quantitative analysts in the hedge fund sector

Doug Ward, Stephen Raby Associates

It seems that the initial hedge fund boom may be over. Last year returns averaged only around 7.5%, compared with around 9.5% in 2004 and over 15% in 2003. And, in the first quarter of 2006, even the best performing funds – long/short – have only seen returns in the region of 7%. The downturn seems to have been caused by a combination of factors acting in concert. First, the strong growth in available assets, which are now estimated at over $1 trillion in comparison to $500 billion in 2000. Second, an exponential growth in the number of managers to nearly 10,000. And third, a reduction in the volatility of the stock market. Taken together, it all means too much money chasing too few opportunities.

Faced with diminishing returns, some players have sought new strategies such as entering less liquid markets like emerging stocks, debt and currencies, credit markets, and private equity. However, many are now pinning their hopes for the future not on new markets, but on the deployment of a relatively new breed of professional in the hedge funds sector – the quantitative analyst.

The role of the quantitative analyst

The term 'quantitative analyst' is a broad and potentially misleading one, which covers a wide range of job functions. Generically it refers to individuals whose responsibilities and experience cover at least some of the following:

  • The development and use of mathematical formulae to price derivative products.
  • Working with traders to create statistical analysis tools for use in developing trading and hedging strategies.
  • Statistical analysis of past trends to predict future market movements and mis-priced instruments.
  • Quantifying in statistical terms the risks their employers are exposed to.
  • Implementation and maintenance of pricing models into usable computer programs (C++/Java/.NET).

Or to put it another way, these are the people who handle the research and development of product, strategy and analytical systems through the use of highly quantitative methodologies.

How they actually fit into a hedge fund will depend on its approach, i.e. whether it is a discretionary or non-discretionary house.In a non-discretionary environment the quantitative analyst will operate in a different way to that commonly seen in a traditional investment bank. They will focus on the 'pure' use of numbers and the building of models that, in effect, systematise the decision making process and take it away, as much as possible, from the humble human. In the discretionary environment, which, perhaps not surprisingly, is still the most common in the hedge fund industry, the quantitative analyst will often be working in a front-line role in support of traders or perhaps even in a quasi-trading role themselves. Whatever their exact role, quantitative analysts bring a whole new level of discipline and risk management to the sector. And consequently the degree to which they are valued will be reflected in the attitudes held by the management of each individual fund. For some, they represent an opportunity for increased legitimacy and effectiveness. For others they are an unwelcome fetter on a fund manager's experience, knowledge and understanding.

Quantitative analysis is currently highly fashionable, particularly in the USA where the industry has resorted to head-hunting finance professors from such top schools as Harvard, Wharton and MIT. However it is no magic bullet to deal with all the challenges and opportunities the hedge fund industry faces and it is far from infallible, even when conducted by Nobel Prize winners. Long Term Capital Management LP had no less than two of the prize winners on board when it collapsed in 1998. The fund's sophisticated computer models and extensive databases proved highly adept at spotting pairs of assets whose value had temporarily moved apart, but failed to take into account macroeconomic factors such as Russia's partial default on its debt which prompted a global unloading of risky investments. The key therefore seems to be not to rely completely and exclusively on the tool, but to use it in conjunction with qualitative assessment and even good, old-fashioned gut instinct. As Charles Hepworth of Morgan Stanley Quilter puts it in an article for FTadviser.com, "Think of quantitative analysis as like watching snooker on a black and white television set. You know roughly what is going on but really cannot see the whole picture. For the plasma high definition view, qualitative inputs are required and here just as the cold mathematical numbers of quantitative analysis show no allegiance, an impartial analysis is paramount."

Recruiting and retaining quantitative analysts – the background

Before you set out to recruit a quantitative analyst it's important to understand the nature of the beast. Practically all quantitative analysts will have a first degree from a top tier institution in a directly quantitative or technical subject, such as maths, a natural science, engineering or computing. In many cases this will have been backed up by an Msc or PhD in a similar area followed by either front or middle office experience in derivative pricing or complex statistical analysis, as well as model implementation.

By their very nature quantitative analysts consequently tend to be conservative, thoughtful and risk averse – perhaps the very antithesis of the classic hedge fund employee. Most will view a move to a hedge fund from the relatively safe and ordered environment of an investment bank as a highly risky and therefore unattractive career move. It means that to catch and hold onto one you may need to develop a completely new set of messages from the ones you are used to delivering to potential hires.

Money, whilst obviously always important, is unlikely to play a decisive part in the hiring process. In general hedge funds do not compete directly with investment banks on base salary. Base salaries in the hedge fund sector tend be around 10% lower than those on offer in the banks except for a handful of very senior posts in large hedge funds where the position occasionally reverses. Instead hedge funds usually seek to attract personnelwith the carrot of significantly higher earnings through substantial bonuses. Let's take as an example the way that a relatively senior quantitative specialist would be paid in the hedge fund and investment banking sectors. In a hedge fund a senior quantitative analyst at head or co-head of research level with some hands-on management responsibility could expect a base salary of between £80-110,000 with a bonus anywhere from £300,000 to £1,200,000. In investment banking a similarly experienced individual at director or MD level could expect a base salary at a slightly higher rate up to £120,000, but with a lower potential bonus which would on average max out at around £600,000. When recruiting highly motivated and bullish traders this approach of focussing on higher total earnings is often highly successful. But when targeting risk averse analysts the success rate is, perhaps not surprisingly, a lot lower.

What quantitative analysts are really turned on by are numbers, and not just the ones on a salary cheque. Throughout all of their adult lives they will have been using complex formulae to solve problems, to spot opportunities, to predict trends. It's what they do, they do it very well and they derive tremendous satisfaction from it. For individuals like this, a large investment bank provides an almost perfect working environment. The best software and hardware, the chance to network with similar-minded professionals, and the time and space to immerse themselves completely within their craft. Which means that tempting them to the more informal, less structured atmosphere of any but the very largest hedge funds is going to be difficult in the extreme.

So how do you do it?

Recruiting and retaining quantitative analysts – the practicalities

The simple answer is often not to target these types of individuals at all. Trying to tempt the classic 'boffin' quantitative analyst is likely to be a waste of time and effort for the reasons outlined earlier unless you are confident that the environment you can offer will genuinely match or outstrip that available in an investment bank. In most cases the type of person who is likely to make a successful transition is not a 'boffin' at all, but someone who combines technical ability with a more commercial approach to their work. And they do exist.

The 'unique selling point' of a hedge fund seeking a quantitative analyst is its ability to provide a more flexible environment than a rigidly structured investment bank. Although some quantitative analysts do work in pure support roles, particularly in larger funds, a growing number work in front-line positions alongside traders, where they can generate as well as test ideas and consequently make a direct and tangible contribution to the bottom line. This ability to offer a multi-faceted role with real involvement in the business, whilst likely to frighten off the traditional quantitative analyst, can prove highly attractive to their more commercial counterpart.

Finding and identifying such people is, of course, not easy. While most hedge funds will be plugged into a network which can help them track down new traders, it is seldom geared up to sourcing technologists of any type and particularly good quantitative analysis talent. These are, after all, people who routinely use (and, even more surprisingly, understand) such esoteric terms as martingales (a zero-drift stochastic i.e. random process, since you ask), antithetic sampling, gamma patterns and Parisian options. Even a search within the natural home of the quantitative analyst, the major investment banks, is no straightforward solution. The commercially oriented analyst in such an environment is often hiding their light under the proverbial bushel. The trick is to be able to identify the right mindset and attitude and to find transferable skills which the individual may not even be applying in his current role.

Doug Ward is a consultant specialising in quantitative analysis roles at the search firm, Stephen Raby Associates