A $13 billion hedge fund is sounding the alarm on one of the biggest trends in investing

Thomson Reuters

• Highfields Capital Management, a $13 billion hedge fund, has raised concerns about quant funds and passive investing in a letter to clients seen by Business Insider.
• Quants use algorithms to make investment bets, while passive funds track market indexes. Both are challenging active managers, the human-backed stock pickers that have traditionally dominated Wall Street.
• Quants, in particular, could worsen the next financial crisis, according to Highfields, an active manager.

A $13 billion hedge fund that flies under the radar is sounding the alarm on one of the biggest investment trends: quants and passive investing.

Highfields Capital Management flagged concerns this week about computer-driven trading in its second-quarter letter to investors, a copy of which was reviewed by Business Insider.

Boston-based Highfields uses a fundamental value-investing strategy, and though it is one of the biggest hedge funds, it doesn't often get much attention.

Quants could worsen the next financial crisis, Jonathon Jacobson, founder of Highfields, wrote in the letter. He highlighted the lead-up to the 1987 financial crisis and partly blamed "portfolio insurance," or "the concept of dynamically hedging an active portfolio with stock index futures."

Portfolio insurance, he wrote, contributed "to the complacency as the market ascended to nosebleed territory and most definitely contributed to the downward spiral of that fateful Friday, Monday, and Tuesday in October 1987."

"The strategies employed by many of today's quant and other systematic investors are essentially the same thing," he wrote. "They weight securities or asset classes based upon their 'risk' as measured by volatility. Much like portfolio insurance, this strategy gives the purveyor the comfort to take more risk than he or she would otherwise take, and 'works' well in benign markets."

A representative for Highfields declined to comment.

Quant strategies have recently pulled in huge amounts of money, becoming some of the biggest players in hedge funds. Renaissance Technologies, a secretive computer-driven fund, increased its assets by about 42% last year, adding $12 billion, and Two Sigma Investments grew by 20%, adding some $5 billion over last year, according to the Hedge Fund Intelligence Billion Dollar Club ranking.

Overall, the end could be near for quant strategies, according to Jacobson:

"The bigger point is that the ability for both passive and quant funds to outperform active, fundamentally oriented managers into perpetuity is improbable at best. In regard to the 'quants,' hundreds of billions of dollars can't exploit the same 'inefficiency' for long. My sense is that we are a lot closer to the end than the beginning of these strategies producing excess returns."

Jacobson also touched on the market's historic low volatility, a common theme in hedge fund managers' recent client letters. Managers usually send letters to their clients in the weeks after the close of each quarter.

Balyasny Asset Management, which manages $12 billion, wrote about quants and passive investors fundamentally changing stock investing, and the $30 billion Baupost Group told clients earlier this month that low volatility could be a harbinger of "the next financial crisis."

Jacobson wrote:

"Common sense would suggest markets should be more fragile, not less. Congress is hopelessly gridlocked. The attempt to reform Obamacare failed miserably. It seems more unlikely every day that either major tax reform and/or some sort of economic stimulus package will be enacted, and these are the twin premises that have underpinned the 'Trump trade.' Central bankers seem determined to end the dual policies of zero interest rates and quantitative easing. And from a geopolitical standpoint, we have a highly inexperienced and impetuous President sitting atop a world that has never seemed more precarious."

He blamed quant funds for the complacency:

"Typically, protracted periods of good market performance are characterized by low volatility and excessive complacency. We can't prove this, but we are convinced that 'quant' funds, which have attracted hundreds of billions of dollars in the last few years and a significant portion of which use leverage, and whose models and various strategies are largely based on price action and correlations extracted from the reasonably recent past when volatility has been low (largely of their own making), have contributed mightily to the illusion that market risk is low. As the money continues to flow into these strategies, this dynamic becomes self-fulfilling."

The Highfields Capital IV LP fund, the firm's biggest fund, with about $5.6 billion under management, returned 1.2% for the first half of the year, according to investor documents. That's compared with a 9.3% gain in the S&P 500 and an 11% gain for the MSCI World index over the same period.

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