Programming languages with an emphasis on data analysis are rapidly finding a place in hedge funds. Data science is fundamentally changing how hedge funds operate.
The Medallion fund of Renaissance technologies has a track record of generating the best return for its investors. According to most estimates, the fund generated returns of more than 60% annualized returns for the past couple of decades. The book ‘The man who solved the market’ by Gregory Zuckerman has chronicled in detail how Jim Simmons built the powerful compounding franchise. The one-word answer is - Data.
Hedge funds minimize their risk by hedging their bets. They use a wide range of strategies and techniques to generate returns on the invested capital. The task of hedge fund managers is to identify securities that have the potential to deliver outsized returns. Then he proceeds to find a hedge for when the strategy fails.
All things said and done, hedge fund strategies hugely rely on the instincts of the fund manager and/or trader. Human emotions and erroneous judgments are involved in decision-making. This is not a prudent investment strategy.
Warren Buffet had predicted that hedge funds will not beat the market returns to generate alpha. He has been proven right in the past decade. Jim Simmons, his Renaissance technologies, and medallion fund are among the very few exceptions. They were able to generate monumental returns when most hedge funds and even Mr. Buffet underperformed the market. The secret weapon in their quiver was data science.
Today a diverse array of fields from waste management to space pursuit use data science. Finance is no exception to this. All hedge funds use data science in various capacities to conduct their operations. Data science helps in identifying opportunities to trade execution. Let us go through how data can be leveraged in various hedge fund operations.
There are more than 43,000 publicly traded equity instruments across the world. On top of that, there are derivatives, debt instruments, commodities, and cryptocurrencies. It is impossible for analysts in hedge funds to scan all the available instruments to identify opportunities.
This is where data science comes in. Python is used to write scripts to scan across the entire financial landscape. The task that could never be accomplished by an analyst can now be completed in mere minutes. This will bring up opportunities that would have eluded regular screening processes.
Trading platforms that hedge funds use generally come with strong Python integration. Python is an easy to learn programming language finance professionals are using in large numbers. Custom functions and applications are created with Python that works with the trading platform. These applications are used to scan for opportunities that fit the modus operandi of the firm. Python also supports process automation. Many screening functions can be automated using Python.
After identifying a suitable instrument, analysts have to create a hypothesis on how the market for it moves. As all financial markets are computerized plenty of data is available for each and every instrument. Hundreds of thousands of trades take place every minute and are recorded. It is impossible for an analyst to go through the complete data.
All trade-related data are structured data that can be stored in a relational database. Information can be queried from the database using SQL. Hedge funds use trading platforms that work well with databases and have extensive support of SQL. Such platforms can be used to perform comprehensive analysis on historical data of any financial instrument. The result of the analysis forms the basis of the hypothesis.
Hypothesis formed is used to build strategies to trade an instrument. Before putting money on the line, it is wise to test the strategy for efficacy. The strategy is implemented algorithmically on historical data as back tests. The results of these tests prove whether the strategy is sound. The results of tests are used to improve the strategy and testing can be done over and over again.
The next step is to test the strategy on live data. Python scripts can be used to virtually implement the strategy with real-time data. Trading platforms come with tools that aid with backtesting and testing with real-time data. New MetaTrader 5 used by hedge funds has a built-in strategy tester to perform these tasks. It is used by hedge funds to test and optimize strategies before real trades are executed with money on the line.
Once strategy is tested, polished, and finalized, it is time to execute the trades. Most exchanges around the world support API based trades. This functionality can be used to build trading bots to execute trades algorithmically.
Stop loss features, risk parameters, strategies for various scenarios, triggers to stop the bot, etc can be built-in to the automated bot. This makes execution completely hands-free and analysts can focus on building strategies. This frees up human capital from routine tasks and can be applied for higher order purposes.
Modern day hedge funds do not employ full-time traders to watch the charts and execute trades. They use trading platforms that support algorithmic trading. Once back testing and real-time testing has yielded positive results, the strategies can be codified as a trading bot with Python. Deploying the bot executes the trades without human interference or supervision.
Hedge funds use data analysis extensively in their operations. There are still a few hedge funds that rely on old-school methods. Overtime they will lose the competitive edge when all the other funds leverage data science and automate trade executions to deliver superior returns. H6edge fund adoption of data science is inevitable.
The use of data science frees up analysts and hedge fund managers to focus on more creative tasks. Their time is better utilized to create new strategies with the insights gained through data analysis. Power of data can connect the dots between seemingly unrelated information and give an edge to hedge funds. Data science will change the future of the hedge fund industry and bring back alpha that eluded the funds in the past decade.