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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 Important legal information The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this 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 the information. Past performance is no indicator for the current or future development. April 2016