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GAM Systematic
APPLYING
QUANTUM
TECHNOLOGIES
November 2016
Quantum mechanics for hedge funds
Dr. Lars Jaeger
Head of Alternative
Risk Premia, GAM
Systematic
When physicists started to
reveal a clearer picture of the
microcosm approximately
100 years ago and a scientific
answer to the question about
what holds the world together
as its inmost folds began to
take shape, researchers
opened their eyes to a world
of atoms that was completely
different to the one that the
ancient natural philosophers
and their modern scientific
successors had imagined.
At the end of one of the most
exciting intellectual journeys
in the history of mankind –
the exploration of the physics
of the atom – stood a theory
whose name still causes a
reverential shudder of incomprehension among non-physicists: quantum theory.
Upon closer inspection, we see striking and
surprising parallels between this and the
development of our understanding of returns
across the global capital markets over the last
10 years, especially those of the former kings
of the investment discipline, the hedge fund.
Prior to the financial crisis, the notion was
widespread among investors that the profits
of this investment vehicle were mainly “alpha”,
which is supposed to be directly attributable
to the intelligence of hedge fund managers.
Thus, an image of the “hedge fund atom” was
predominant until 2008 which was very similar
to the atomic model of physics from 1903
prevalent before quantum mechanics (which
is referred to as the “Thomson atomic model”):
an inhomogeneous sphere mainly consisting
of the “alpha”, plus a little bit of “beta” and
“epsilon” as additional components. The former represents the broad market returns and
the latter the inexplicable returns generated by
accident (in other words: luck).
The Hedge Fund Atom
Today we have a much clearer image of the
“hedge fund atom”. And this image also resembles a physical atomic model: that of modern
quantum mechanics which Nils Bohr was
the first to formulate in 1913. We see the total
“mass” unified in the nucleus and the electrons
move around this nucleus. The high-mass
nucleus consists of different versions of betas,
while the electrons represent the alpha. In other
words, the main weight of hedge fund returns
lies in general risk premia across the global capital markets.
However, these risk premiums are not the well-known “long only”
equity or bond premia; they go beyond these, which is why they
are also referred to as “alternative”. These premia can be measured, respectively extracted, systematically with computer-based
trading models using well-known investment techniques such as
“short selling” (“spread trading”), the use of derivatives, dynamic
trading, or leverage being employed by hedge funds.
From Hedge Fund Replication to Alternative Beta Strategies
Discovery of the “atom” in hedge fund returns
Crisis of classical physics
The atomic model according to
modern quantum physics
The atomic model in 1895
Crisis of hedge fund industry
Model of hedge funds
returns in 2007
Hedge fund return model today
Source: GAM
The ugly duckling transforms into a powerful swan
The study of systematic sources of return now also constitutes
a key area of academic finance. Returns beyond the well-known
non-directional factors such as “value” or “momentum”, are
discussed at great length in the relevant reviewed journals
today. Previously described as “alpha”, we came to realise that
systematically extractable alternative risk premia are the key
components of hedge fund returns, just as our new atomic
model describes them. What does this mean for investors?
While the appeal of alpha is obvious (who doesn‘t like earning
money without any market risk?), the charm of beta is less
glamorous, but at the same time it is easier to obtain. Beta –
whether in a traditional or alternative form – can be described,
modelled and, ultimately, replicated systematically. The latter
could solve the annoying problems of significant costs, low
transparency and the long redemption periods hedge funds
have bothered investors with for decades without losing the
alternative investments’ benefits of attractive returns with low
correlations to traditional portfolio components. The once ugly
duckling “beta” has thus developed into a powerful and strong
swan within the alternative investment industry.
Alternative Beta elementary particles
The atoms that were once considered indivisible are now
described in physics as compositions of elementary particles
such as neutrons, protons and electrons. We should therefore
also imagine the returns from liquid alternative investment strategies as a combination of various “alternative beta elementary
particles”. What we have experienced in the last few years is
nothing less than the development of a fundamental theory for
(liquid) alternative investment returns based on alternative risk
premia. Or to use the same metaphor from modern theoretical
physics: a “quantum mechanics for hedge funds”. The complex
and non-stationary behaviour of these individual “particles” can
be described and illustrated through conditional trading rules
and ultimately combined in attractive investment portfolios,
in the same way that the atoms of physics form the molecules
of chemistry and further compounds and solids. Systematic
strategies for alternative risk premia help us to convert our new
knowledge into real investment products which are able to turn
the old promise of hedge funds into a modern investor-friendly
structure. This could have a lasting impact on the financial
and investment industry, just like the application of quantum
mechanics did on the chemical industry and industrial technology of the 20th century. And the latest quantum technologies
show us that the range of quantum physics applications is far
from being exhausted in the 21st century.
For more information, please visit www.gam.com
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document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of
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April 2016