T U E S D AY 2 6 M A R C H 2 0 1 9THE BIG READ

D. E. Shaw and Company

DE Shaw: inside Manhattan’s ‘Silicon
Valley’ hedge fund

Secretive group mixes quant investing with common sense, but is fighting tokeep its $50bn edge
R O B I N W I G G L E S W O R T H – N E W YO R K

Breaking the code: David Shaw, the hedge fund’s founder, has passed day-today control of the company to an executive committee FT montage/Getty Images

In 1988, Revolution Books, atatty Communist bookstore
near New York’s Union
Square, got some strange newupstairs neighbours: a bunchof geeky programmers trying
to crack the code to financial
markets.
In the early days, theembryonic hedge fund foundedby David Shaw, a former
computer science professor
at Columbia University, was aramshackle start-up. Exposed
pipes and extension cords
meant that tripping on a cable
could take out its entire trading
system. Yet today DE Shaw is
one of the hedge fund industry’s
biggest players, managing over
$50bn of assets.
It has enjoyed somemainstream fame as the place
where a young Jeff Bezos
first worked on what would
ultimately become Amazon.
But most importantly for awider investment industry
desperately trying to reinvent
itself for the 21st century, DE
Shaw has evolved dramaticallyfrom the algorithmic,© THE FINANCIAL TIMES LIMITED 2022

computer-driven “quantitative”
trading it helped pioneer in the1980s.
It is now a leader in
combining quantitative
investing with traditional“fundamental” strategies
driven by humans, suchas stockpicking. Thissymbiosis has been dubbed“quantamental” by asset
managers now attempting to dothe same. Many in the industrybelieve this is the future, andare rushing to hire computerscientists to help realise
the benefits of big data andartificial intelligence in theirstrategies.
Eric Schmidt, the former
Google chairman who owns a
20 per cent stake in DE Shaw,
predicts that this approach
will profoundly reshape theinvestment management
industry. “People have gone
insane about this, but in a goodway,” Mr Schmidt says. “We areat the beginning of a new era
in artificial intelligence. These
technologies should benefit
investing as well.”There are plenty of pitfalls
though, with experts warningthat poor implementation canlead to disastrous results. WallStreet has seen several cyclesof quant hype before, andmany remain sceptical thattraditional firms can retool
their culture sufficiently tounlock the potential advantagesof a more hybrid approach.
The combination of DE
Shaw’s performance and thesecrecy around exactly what it
does both vexes and fascinatesrivals and counterparties.
“They’re like a calibrated
machine that can respond tonearly every market,” says thehead of an investment bank’s
hedge fund trading desk. Ina series of interviews withsenior DE Shaw executives, theFinancial Times has had a rare
glimpse of how the “machine”
operates.
Little known outside
investing’s arcane corners,
DE Shaw is the fourth-highest
grossing hedge fund group of alltime, having made over $29bn

for its investors since thoseearly days near Union Square,according to LCH Investments.
Last year its flagship $14bn
Composite Fund — which has
been closed to new investors
since 2013 — returned over 11
per cent to investors net of fees,
despite the turmoil in financialmarkets. That was its seventh
double-digit gain of the past
decade, over which period it has
not suffered a losing year. Its$7.6bn “macro” fund, Oculus,
returned 5.9 per cent in 2018,
and the $7bn stocks-focused
Valence made 8 per cent.
Even among peers on WallStreet, DE Shaw is still a largely
unknown quantity. “They’rereally smart, but I’ve neverquite understood them,” says
one quant hedge fund manager.
“They are one of those places
where you just don’t know
exactly what [it is] they do,
except that it is some mix ofquantitative and discretionary
investing.”
This hybrid approach is
not new. DE Shaw venturedout of its quantitative roots

THE BIG READ
soon after its founding. But
it now manages a wide arrayof strategies, ranging fromcompletely machine-driven
and dizzyingly complex, tohuman and artisanal, such as“distressed debt” investing andactivism.
Roughly half of the $50bn it
manages are in quant strategies,
and the rest in discretionary or
more hybrid funds.
“The world tends toview quantitative and fully
discretionary investing as
distinct and separate, butthe opportunity set [to makemoney] is not as cleanlydivided,” says Max Stone, oneof the five members of DE
Shaw’s executive committee,
along with Eddie Fishman, Eric
Wepsic, Julius Gaudio and AnneDinning.
Some rivals question
whether it has departed too far
from its roots. For instance,
Two Sigma — a major quanthedge fund started by former
senior DE Shaw executives— has eschewed their former
colleagues’ hybrid methods.

Former Google executive Eric
Schmidt has a 20 per cent stake inDE Shaw © Bloomberg

DE Shaw executives stressthat their one constant is tohave a data-driven “quanty”
approach across the board,whether it is in high-speed
arbitrage or investing in
renewable energy. “Ourcore strength is thinking
scientifically about things,
so it doesn’t feel like we are
wandering away from ourroots,” says Alexis Halaby, headof investor relations at thecompany.
It currently employs
about 1,300 people, which
includes over 80 PhDs and 25
International Math Olympiad
medal holders. All interviewees
at DE Shaw face a series© THE FINANCIAL TIMES LIMITED 2022of analytical questions todemonstrate their suitability towork there — something evenformer US Treasury secretary
Larry Summers had to go
through ahead of a stint at thefund in 2006.
That approach seeps throughinto the culture, say observers.
Mahmood Noorani, a former
hedge fund manager who
now leads Quant Insight, ananalytics company, describes
the people at DE Shaw as “lessalpha male and more gentle
scientists”.
This has helped the company
survive the type of leadershiptransition that has felled somerivals.
Most hedge funds see theirfortunes fade once theirfounder steps down, but DEShaw has thrived since Mr
Shaw, 67, semi-retired in
the early 2000s to pursue
research into “computationalbiochemistry”.
Fittingly for a company
started above a bookstore
selling Marxist treatises, theday-to-day running of thehedge fund is now handled
by the central committee
of five, rather than a single,
imperial impresario typical of
the industry. “You’d be hardpressed to find a management
textbook that says a committee
is a good way of running acompany,” says Mr Stone. “Butit works for us.”This was among the factorsthat attracted Mr Schmidt when
he scooped up the 20 per centstake in DE Shaw held by thebankrupt estate of Lehman
Brothers in 2015. “It feels like
Silicon Valley in Manhattan,”
he says. “People get consumedby hierarchy, but the evidenceshows that flat structuresand diverse teams operatingcollectively have betteroutcomes.”
Sometimes things go awry,
however. In an unusually public
spat for a company that shuns
publicity, DE Shaw last year
fired Daniel Michalow, a seniorfund manager, after an internal
review found “gross violationsof our standards and values”.
In an open letter Mr
Michalow conceded thathe might have deserved hisdismissal for being “an abrasiveboss” but insisted that hisdeparture was not related toany sexual misconduct. He did,
however, paint a very different
picture of DE Shaw criticising
the hedge fund for “lavish,alcohol-filled parties” and said
visits to strip clubs and senior
employee relationships with
their juniors were common. DE
Shaw declined to comment on
the accusations, citing ongoinglegal proceedings.
Mr Michalow is suing DE
Shaw for defamation andother claims relating toDE Shaw founder David Shaw
remains chairman of the hedge fund© Bloomberg

the announcement of histermination.
The hedge fund’s executives
are happier to discuss how it
manages money, even if thedetails can be opaque. DE Shawruns some quant strategies
so complex or quick thatthey are in practice almost
beyond human understanding— something that many
quantitative analysts are
reluctant to concede.
The goal is to find patterns on
the fuzzy edge of observability
in financial markets, so faintthat they haven’t already been
exploited by other quants.
They then hoard as many ofthese signals as possible andsystematically mine them until
they run dry — and repeat
the process. These can range
from tiny, fleeting arbitrage
opportunities between
closely-linked stocks that only
machines can detect, to using
new alternative data sets suchas satellite imagery and mobile
phone data to get a better
understanding of a company’sresults.
Yet, the hedge fund’s
executives say they alsofrequently use common
sense to overrule theiralgorithms, another anathemain an industry where humantinkering can be considered afoible.
Some of these manualinterventions are obvious. For
example, when Russia annexed
the Crimean part of Ukraine
in 2014 and started fomenting
unrest in its eastern province,
DE Shaw quickly dialled backits exposure to the Moscow
stock market. And when theVolkswagen emission cheating
scandal erupted a year later— another of the unexpected
shocks that machines are
ill-equipped to deal with —it pared back bets on thecarmaker.
Other strategies require aheavier human hand, such as
taking advantage of periodicallywide discrepancies between
Tencent and Naspers, the SouthAfrican holding company thatowns nearly a third of theChinese tech giant. Normallythey trade in lockstep, butsometimes they diverge
because of broader emerging
market stress or South African
politics — opening up a valuableTHE BIG READ

opportunity. The optimal time
to pounce can be modelled,
but is best paired with thediscretion of a human fundmanager.
Yet, DE Shaw still sees
plenty of opportunities in thequantitative investing side,
especially its “long-only”,
non-hedge fund investing
business, DE Shaw Investment
Management. DESIM hasquintupled in size since 2011
and now manages $24bn. To
grow this further, the company

is expanding into something
dubbed “risk premia”,
systematically exploiting
theoretically timeless drivers of
returns, such as the tendency
for smaller or cheaper stocks tooutperform the overall market
over time.
Historically these havebeen factors that hedge funds
might explicitly or indirectly
harness — and charge hefty
fees for — but they have now
been packaged up into simpler,cheaper vehicles by the likes ofFor many, the summer of 1998 wasdefined by the Monica Lewinsky scandalenveloping the White House, the SpiceGirls losing a member and France’s
stunning victory at the football WorldCup. But for the finance industry, thatsummer will forever be remembered
as the period when some of the finest
minds on Wall Street came undone.
The collapse of Long-Term CapitalManagement, the hedge fund led by
Salomon Brothers’ former star trader
John Meriwether and advised by Nobel

AQR and BlackRock.
DE Shaw is also ramping
up its investment in thebleeding edge of computerscience, setting up a machinelearning research group led byPedro Domingos, a professorof computer science andengineering and author of The
Master Algorithm, and investingin a quantum computing startup.
It is early days, but Cedo
Crnkovic, a managing director
at DE Shaw, says a fullyfunctioning quantum computer
could potentially prove
revolutionary. “Computing
power drives everything, andsets a limit to what we cando, so exponentially morecomputing power would betransformative,” he says.
Nearly every traditional
investment company isscrambling to hire data
scientists, programmers
and technologists, and turnthemselves into humanmachine hybrids. DE Shaw’s
apparent success in bridging
those two worlds offers analluring template for rivals.
However, many “pure”

laureates Myron Scholes and Robert
Merton, hogged the headlines. But themarket maelstrom also nearly killed DE
Shaw, which had made many of the same
trades as LTCM with similarly massive
dollops of leverage. “The market
environment was harrowing,” says Eddie
Fishman, who now sits on the DE Shaw
executive committee. “But the lessons
served us well in subsequent crises.”
The 1998 crisis, and the “quant quake”
in August 2007, are reminders thateven the most sophisticated computerpowered strategies can implode. Given
the popularity of quantitative investing
and the competition to find and mine
new trading signals, there are concernsthat markets are primed for a rerun.

quants are sceptical thattraditional asset managers
have the cultural architectureneeded to make a success,arguing that companies cannot
just hire a bunch of computerscientists, tell them to workwith 50-year-old fund managers
with MBAs and hope thatmagic will ensue. Others fretthat by not fully grasping thelimitations, they might even dodamage to themselves, and orinvestors.
Mr Stone has a stuffedalbino peacock sitting on acabinet in his office, a reminderthat sometimes markets —like nature — serve up theunexpected. He is wary ofcriticising the quantamental
rush, but also cautions that it
could end in tears.
“There are some good ideas
at the intersection of systematicand discretionary investing,”
he says.
Nonetheless, “if you don’t
have experience of separating
signal from noise,” he adds,“you can easily be led astray byextraneous data.”

History indicates that the two main
dangers are leverage and “crowding”.
The toxicity of aggressive leverage —whether debt or through derivatives — iswell-known, but too many investors
crowding into the same security or trade
can also cause severe damage, especiallywhen trading conditions deteriorate
quickly.
While most hedge funds use far lessleverage than in 1998 or 2007, the sheer
amount of money raised by quant funds
since the crisis is leading to fears ofcrowding, lowering returns for everyone
and ultimately raising the risk of an
abrupt reversal, which would in turn leadto a crash as burnt investors dash for theexit.

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© THE FINANCIAL TIMES LIMITED 2022