Pillsbury Investment Funds practice co-leader Ildiko Duckor recently spoke with The Hedge Fund Law Report about the strategies and risks inherent in investing in and managing quant funds, which utilize highly sophisticated computer-based models to automate trading activities and are increasingly popular in the “hyper-connected” trading and investment sector.

It’s important for managers to be well-versed in the unique operational and marketing challenges that quant funds raise. Duckor started by explaining the basic differences between quant funds and high-frequency trading strategies, distinguishing the risks they each present.

“High-frequency trading strategies exploit split-second trading decisions, which can present a much higher market risk … because high volumes are involved, which can move the market quickly and to a large degree,” she said. “High-frequency trading strategies are also more susceptible to potentially fraudulent practices. With quant funds pursuing a long/short strategy … while large funds can obviously present systemic risk, trading is not going to pose risk in a flash on a systemic basis.”

In that sense, Duckor says, quant funds are akin to typical fund trading, notwithstanding that their trading decisions are primarily made by a computer-based model of output.

Duckor also says that fund managers must be aware of potential conflicts of interest if they run funds that use different quant strategies, which is common, and that it’s important for disclosures to offer sufficient detail about the strategy in use. She recommends that managers take these steps:

  • describe what each strategy does
  • provide comparisons of the similarities and differences of the strategies (e.g., exposure differences, position overlaps, volatility, turnover, etc.)
  • discuss what actions each strategy might require (especially if overlapping positions are traded differently)
  • explain the potential consequences of those different actions
  • disclose the potential conflicts of interest and their possible effects

Duckor also says she is again seeing more and more investors seeking out quant funds, and that these investors undertake a rigorous review process.

“What they look for … is controls addressing model maintenance: design, implementation, effectiveness of use and detection and correcting of programming errors,” she said. “There is no such thing as a perfect model. The risk of malfunctions and anomalies is inherent in each component of the programming process and how those components function together. The investor … will look at how the code is being maintained and how the model is being tested and improved on a continuous basis.”

Another issue for all fund managers to consider, especially with quant funds, is cyber risk.

“Quant managers may face a heightened risk or more dire consequences of cyber attacks,” Duckor said. “Cyber criminals specifically target hedge funds because if they steal algorithms, then they have access to the ‘golden egg’ and can replicate the strategy.”

She recommends that fund managers pay close attention to the security measures their cloud storage vendors have in place and “diversify their risk” by hiring multiple data firms. Duckor also tells HFLR that simply outsourcing compliance functions of the business to a consultant is not good enough—a fund’s compliance procedures must include daily surveillance and testing.

“Given these challenges, it is especially important in the quant space to have a concerted effort among portfolio managers, programmers and the chief compliance officer to bridge the gap between the programming and the compliance/regulatory knowledge,” she said.