I wanted to take some time to go into more detail about our investment philosophy. You can find our formal investment philosophy on our About Us page.

A Systematic Foundation

No man is better than a machine, and no machine is better than a man with a machine.

-Paul Tudor Jones

In today’s hedge fund world, it’s practically impossible to compete long-run without leveraging technology. It’s easier to access financial data now than ever before, there is way more data out there and the amount of it continues to grow at an exponential rate. Sophisticated investors, whether taking a quantitative or discretionary investment approach, are now forced to use the machine to make decisions every day.

Now, you can’t rely on the machine to do everything. Risk is still inherently human – there will always be market events that cannot be explained by a quantitative model. Humans write the code that executes the majority of all electronic trading, and as we know, humans make mistakes (and sometimes big ones). One of the mistakes we think most quants make is relying too much on their trading model. Knowing when to turn a model off can sometimes be much more valuable then turning it on in the first place.

Also, relying too much on one model (alpha) brings about many hidden risks and exposes you more to return decay. Too many traders try to find the single best (holy grail) trading strategy. In reality, even if you do, the fact that it is so good only increases the probability that another sophisticated trader will also discover it and quickly reduce its edge.

Instead, we believe in cultivating a diversified portfolio of many uncorrelated, structural alphas. On their own, each alpha may not be as good as a “holy grail” strategy (at least in past history / backtests!), but the sum is greater than its parts. Such an investment approach, properly implemented, directly increases the robustness of the overall portfolio and significantly reduces hidden systemic risks.

In summary, we believe that the best way to maximize risk-adjusted return while having low correlation to major market factors is to build & maintain an assembly line designed to methodically produce robust alphas across global markets. Our investors are not investing in a trading strategy, but rather in an experienced team who maintains and continually improves a process of developing trading strategies.

However, to stop there leaves some money on the table.

Opportunism

The way to make money is to buy when blood is running in the streets.

-John D. Rockefeller

Financial markets have generally become more efficient as a direct result of competition. There is now over 3 trillion USD managed by thousands of sophisticated hedge funds, compared to a handful of these funds in the 1970s. It is much harder today than ever before to squeeze out alpha on a day-to-day basis.

Although the maturation of the investment management industry has generally made it harder to generate alpha, we believe it’s also created new market dynamics that can translate to large opportunity.

A good example is the effects of the saturation of the hedge fund industry. Due to the level of competition (as well as poor incentive structures), many funds are indirectly encouraged to replicate similar portfolios. This phenomenon can be seen in average hedge fund returns; hedge funds are now much more correlated to macro factors, and each other, than ever before.

Therefore it’s tougher to generate alpha during normal market environments – everyone is competing in the same arenas. This herding however creates great systemic risk (think the quant crisis in August 2007). When too many funds are trading a very similar strategy, and for whatever reason that strategy experiences a significant loss, very quickly you can have a systemic “run” on the strategy and the effect snowballs until funds hit their risk limits, capitulate, and ultimately blow out.

These are the times of greatest opportunity. Forced, mandated, structural liquidity arbitrage.

We believe that the readiness to take advantage of these opportunities are what sets apart good investment managers from great ones.

Next week I’m going to review an example of one of those rare opportunities, and how XMonetae plans on continuing to take advantage of them moving forward.