With all the talk of automated hedge fund replication and hedge fund “cloning” these days, it’s easy to discount the role of that apparently antiquated technology, the human being, in hedge fund management.
Now Jonathan Treussard of Boston University claims that while robotic algorithmic trading is a critical element of any hedge fund replication technique, “it may come at a high price in terms of adaptivity, dynamic flexibility and risk selection“.
Jut don’t let the robot union find out that human fund managers might be coming back for their jobs!
Human capital is, of course, the scarce resource underlying most hedge fund strategies. And exceptions to this rule are generally the ones most scared of the concept of hedge fund replication. Treussard argues that human capital, not investment strategy per se is the reason for “the industry’s remarkably high remuneration structure“.
Previous studies such as this one cited by Treussard have also suggested that there is a certain je ne sais quoi in high alpha-producing hedge funds that can be attributed to human ingenuity.
So which funds and strategies can benefit most from using this exotic technology called “humans”? Treussard says ones that make “trades for which there is a significant amount of uncertainty regarding the speed of convergence or the chances of divergence.”
He illustrates mathematically that a hedge fund’s “discounted lifetime expected value” is essentially the difference between the cost of a trade and its pay-off less human capital. Human capital creates greater certainty about the timing and volatility of trades and thus creates option-like, positively-skewed returns. Therefore, says Treussard, the “optimal” amount of human capital would be an amount high enough to increase the pay-off without blowing the operating budget of the hedge fund.
“…a higher commitment of resources to the retention of human capital allows the fund to make more informed trades (i.e., more human capital raises the value of the implicit quasi-option)…”
Last fall, in an Economist-inspired posting on “talent”, we said that new activities often require human capital in the beginning, but eventually progress toward semi-automation:
“Long ago, ‘transformational’ jobs may have required a lot of judgment. After all, converting copper into bronze tools sounds pretty complex to me. The cave man that figured this out must have been pretty talented.
But new technologies and processes eventually moved the cave men up the learning curve until bronze became a commodity. This cycle of commoditization, where previously complex tasks become commonplace (and inexpensive) reminds us of Pranay Gupta and Jan Straatman’s paper on ‘commoditized’ and ‘non-commoditized’ beta (first brought to our attention by our friend Richard Kang at Seeking Alpha). These two ABP executives argue that alpha is just beta that hasn’t been commoditized yet. They might also argue that ‘tacit’ jobs are just ‘transformational’ jobs that haven’t been commoditized yet.”
Unlike us, however, Treussard backs up his beliefs using extensive mathematical proofs that make heavy use of calculus and outnumber words on many of the study’s pages. The only number we could come up with was in the date field produced by WordPress.
Treussard takes the broad concept of human capital to a molecular level and shows how human capital can actually be measured and evaluated. Since trades are constantly being commoditized and investment opportunities constantly being arbed away, it seems that human capital may be the only sustainable competitive advantage available to hedge fund companies in the future. In Treussard’s words:
“Hedge funds, traditional and clones, are faced with the evaluation of an ongoing flow of potential arbitrage opportunities. Each fund must decide those on which to trade and those on which to pass. What distinguishes funds is the quantity of human capital employed in this evaluation and decision-making process.”