This Old School Hedge Fund Is Going Quant Rob Copeland

Rob CopelandEVANSTON, ILL.—Alec Litowitz, founder of one of the country’s largest hedge funds, raised a simple question at the firm’s investment committee meeting: How often do mergers fall apart?

No one had the answer, so the Magnetar Capital LLC founder assigned a team of analysts to pore through three decades of data to find out. They calculated that while 7% of announced transactions eventually collapse, the market behaves as if nearly twice as many do.

Mr. Litowitz reasoned a computer program could make money exploiting that discovery and thousands of others. So he posed a second question: “What if we could take what was in our head and our database and make rules out of it?”

So began six years ago a billion-dollar quantitative effort at Magnetar designed to help the $13.5 billion firm buck a hedge-fund massacre waylaying its peers and set to rest memories of controversial trading by the firm on subprime housing during the financial crisis.

Like high-end restaurants, hedge funds often roll out new menus to entice investors to keep coming back, and quantitative trading is the latest special du jour. In the wake of years of disappointing investment performance and client defections, hedge funds are emphasizing a systematized, algorithmic approach to investing. That is a change from the hand-over-your-money-and-just-trust-us pitches of an earlier era.

Magnetar’s quantitative push is different from many of its high-speed quant competitors, who parse reams of data in the hunt for an edge—even one they can’t explain. Magnetar is taking a more manual approach. Discoveries such as the types of corporate acquirers are more likely to see through to the end of a tough deal, are translated into computer algorithms

algorithm

Set of rules that can parse data and automatically decide what to buy and sell.

that trade automatically.“We start with intuitions and then go see if the data backs it up,” says Mr. Litowitz. “Most people reverse it. They go looking for data and then go find a signal that explains it.”

The shift is particularly remarkable because Magnetar and Mr. Litowitz for years represented the prototypical headstrong hedge fund, investors and industry executives say. An adrenaline junkie who competes in triathlons and off-road mountain bike races, 50-year-old Mr. Litowitz was one of Kenneth Griffin’s first hires at hedge-fund giant Citadel LLC. He racked up such profits that Mr. Griffin awarded him part-ownership of the firm.

Mr. Litowitz left to start Magnetar in 2005. The firm launched with $1.8 billion in capital, marking one of the largest hedge-fund launches of the time. The firm commanded high fees even by the standards of the era, passing on many of its costs directly to investors.

Since inception, Magnetar’s flagship fund has reported only two down years, with an average annualized return of roughly 5%, after fees.

Similar to many hedge funds, however, investors have pulled more from Magnetar than they have put in of late. The firm still manages nearly as much assets as it ever has thanks to positive investment performance including 8% gains in each of the past two years for its newest quantitative vehicle, investor documents show.

The firm was investigated by the Securities and Exchange Commission after the crisis for its role in creating mortgage securities that suffered billions of dollars in losses in the housing swoon. The firm consistently denied wrongdoing, and the probe was closed with no charges brought.

Magnetar is pouring tens of millions of dollars annually into researching new techniques for investing.
Magnetar is pouring tens of millions of dollars annually into researching new techniques for investing. Photo: Lucy Hewett for The Wall Street Journal

Mr. Litowitz, whose parents were psychoanalysts, now describes the public flogging the firm received as “not my favorite period, but probably partly our responsibility a little bit, having not done the greatest job of articulating what we did.”

Independent of the investigation, Magnetar executives had concluded some of their old trades, such as spotting discrepancies in complicated financial instruments like convertible bonds, had grown tired. Thus began a shift into new areas such as quantitative trading and investments in big money transactions like Hollywood movies and commercial jets.

“What worked in the past will not necessarily work in the future,” Mr. Litowitz says. “The traditional hedge-fund world has to come to grips” with a new reality, he said.

Magnetar is pouring tens of millions of dollars annually into researching new techniques for investing. One-fifth of the firm’s 260-person staff now works in technology. A stand-alone Minneapolis office houses quantitative researchers who produce sometimes counterintuitive advice. In one example, they advised the firm’s investment staff to largely ignore traditional metrics in stock picking like executives’ ownership of their own company’s stock because such statistics are weak predictors of company short-term performance.

Magnetar’s quantitative PRA fund eclipses its hedge-fund peers.Growth of a $1,000,000 investmentTHE WALL STREET JOURNAL.Sources: Magnetar investor documents; HFR
Magnetar PRAHFR fund weighted composite index2015’16950,000975,0001,000,0001,025,0001,050,0001,075,0001,100,0001,125,0001,150,000$1,175,000

“Everybody in this industry is suddenly saying: ‘Couldn’t a robot do that?’” said Sean McGould, president of Lighthouse Investment Partners, which puts client money with Magnetar.

In fixed income, which includes half the firm’s assets, Magnetar executives say only 15% of the firm’s investments now constitute old school hedge-fund bets like deciding one-by-one when to zip in and out of securities. The firm cast a wide net for the next big wins, in one instance scoring handsomely on Chinese e-commerce giant Alibaba before its public debut, and in another investing in thousands of commercial trucks and single-family homes.

“We would have never thought we’d ever be in these businesses before,” says Dave Snyderman, Magnetar’s global head of fixed income.

From left, Alec Litowitz, Magnetar’s founder and CEO; David Snyderman, global head of fixed income; and Ross Laser, co-founder and president. Magnetar executives say there still remains a key role for human decision-making.
From left, Alec Litowitz, Magnetar’s founder and CEO; David Snyderman, global head of fixed income; and Ross Laser, co-founder and president. Magnetar executives say there still remains a key role for human decision-making. Photo: Lucy Hewett for The Wall Street Journal

Magnetar also began telling investors it would waive some fees tied to performance unless it could beat a market benchmark. Such an attitude was long anathema in the hedge-fund world, where a flat charge of 2% of assets under management and 20% cut of all profits has been the industry standard.

“It’s rare, because most people are creatures of habit,” says J. Tomilson Hill, vice chairman of the Blackstone Group LP, which bought a minority stake in Magnetar in 2015, confident it could outlast a global hedge-fund malaise. “If you’re not constantly innovating…you run the risk of going obsolete.”

In one previously unreported move, Magnetar recently parted ways with its head trader—a top role at most hedge funds—to instead move to a committee-based approach where no single individual holds the power, people close to the firm say

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