Hedge Funds Embrace Quantitative Investment Strategies Amid Growing Adoption

Hedge funds now account for up to 10% of QIS assets, with total exposures reaching $552 billion in December.

By Mackenzie Crow

6/11, 08:12 EDT

Key Takeaway

  • Hedge funds are increasingly adopting Quantitative Investment Strategies (QIS), with notional exposures hitting a record $552 billion in December.
  • QIS offers hedge funds a cost-effective way to gain exposure to various asset classes, despite initial skepticism and concerns over rigidity and performance.
  • Challenges remain, as 76% of QIS strategies underperform after going live, and nearly 1,900 out of about 7,000 indexes have been retired.

Hedge Funds Embrace QIS

Wall Street's half-trillion-dollar business of cloning quant trades, known as quantitative investment strategies (QIS), is seeing a surprising shift in its customer base. Hedge funds, which once criticized these copycat products, are now becoming significant users. QIS tools replicate popular systematic trades and turn them into swaps or structured notes, offering a quick and cost-effective way to gain exposure. Historically, hedge funds like AQR Capital Management and Dimensional Fund Advisors have been skeptical of QIS, viewing them as inferior imitations of their sophisticated strategies. However, the convenience of QIS is winning over money managers.

Pierre de Saab, a partner at Geneva-based Dominice & Co., has started using QIS despite previously arguing that their rigidity makes them less effective during market selloffs. "It can be challenging to hire a trader every time you want to do something new," said de Saab. He now uses QIS to put on new positions, which make up about 5% of his portfolio. The adoption of QIS is accelerating, with total notional exposures reaching a record $552 billion in December, according to an Albourne Partners survey.

Growing Adoption and Uses

Banks initially targeted institutional investors like pensions with QIS, but hedge funds are now a growing customer base. Giulio Alfinito, global head of QIS structuring at UBS Investment Bank, estimates that hedge funds now account for a high single-digit or even double-digit percentage of notional QIS assets at some banks. "If we can live within that ecosystem, it is a good source of validation for our algorithms," he said.

Hedge funds use QIS in various ways. For example, a fixed-income team at a multi-strategy hedge fund might trade stock options with QIS, or a firm new to commodities might use QIS to gain quick exposure to raw materials. "To multi-pod type of hedge funds, QIS is a cheap way for them to get access to an asset class where a team doesn’t have trading capabilities," said Arnaud Jobert, co-head of global strategic indices at JPMorgan Chase & Co. JPMorgan runs a notional $85 billion in the QIS business.

Challenges and Criticisms

Despite the growing adoption, hedge funds remain cautious. Banks selling QIS are not asset managers and have no fiduciary duty to the client. The strategies are executed based on a predetermined rulebook, making them inflexible and potentially more expensive to trade. Deniz Cicek at Axonic Capital expressed skepticism, saying, "My investors can do it themselves, so what’s my value?" He believes the edge for hedge fund managers lies in knowing when to enter and how much to invest, rather than just getting static exposure.

QIS are often marketed based on backtests, but the actual performance can differ. John Downing, who runs a QIS-based ETF at Simplify Asset Management, noted, "A big consideration is the live return versus the backtest." Pierre de Saab's analysis of over 1,000 strategies showed that about 76% delivered a lower risk-adjusted return after going live, with 32% even going negative. Critics argue that the high failure rate of QIS indicates that banks are merely experimenting to see what works. Data provider LumRisk reported that nearly 1,900 out of about 7,000 QIS indexes have been retired, with a record 392 retiring during the Covid volatility of 2020.

Street Views

  • Pierre de Saab, Dominice & Co. (Neutral on QIS):

    "You can use QIS as a starting point, and also as a way to outsource execution so that your staff can work on higher added-value tasks."

  • Giulio Alfinito, UBS Investment Bank (Cautiously Optimistic on QIS adoption by hedge funds):

    "If we can live within that ecosystem, it is a good source of validation for our algorithms."

  • Arnaud Jobert, JPMorgan Chase & Co. (Bullish on the utility of QIS for hedge funds):

    "To multi-pod type of hedge funds, QIS is a cheap way for them to get access to an asset class where a team doesn’t have trading capabilities... Five or 10 years ago, there was very little hedge fund adoption. If anything, hedge funds could see QIS as a competitor."

  • Deniz Cicek, Axonic Capital (Bearish on equity QIS):

    "My investors can do it themselves, so what’s my value? As a hedge fund manager, I think the edge is knowing when to get in and how much money to put in these exposures rather than just getting static exposure."

  • John Downing, Simplify Asset Management (Cautiously Pessimistic on backtested performance of QIS):

    "A big consideration is the live return versus the backtest... It might be a victim of its own success where you have so many folks chasing the same premium."