The Strategy Behind Citadel’s Plan to Pay Hedge Fund Peers for Trading Ideas

T.S. Eliot famously wrote that “immature poets imitate; mature poets steal.” Thankfully, mature hedge funds have more than enough money to pay for ideas.

Bloomberg News reported Tuesday that Miami-based Citadel, the high-flying hedge fund run by art-collecting billionaire Ken Griffin, is planning a new initiative that will compensate other hedge funds for trading signals.

Quant It All

Citadel’s plans fall into a category called alpha capture. Essentially, it’s the practice of collecting trading strategies and ideas from external sources in exchange for a fee. Brokers, analysts, up-and-coming fund managers and boutique hedge funds with niche expertise can submit ideas and typically get compensated if their submission is validated. The concept was the brainchild of British hedge fund Marshall Wace, which launched the world’s first alpha-capture application, the Trade Optimized Portfolio System, in 2002. TOPS crowdsources and aggregates ideas from thousands of vetted, sell-side financial professionals.

That the concept bloomed in the early 2000s was no coincidence. The rapid growth of computing power and digitization of vast amounts of data gave rise to the quantitative analyst, or quant. Quants are financial professionals who use advanced math, statistics and computer programming to find patterns in market data to gain an investing edge, including by using tools designed to rapidly execute trades. It was Wall Street’s Moneyball, in other words, where funds competed in an arms race to unearth hidden insights from data the same way front offices in baseball turned to sabermetrics. Quantitative strategies, of course, are now part of the lifeblood of hedge funds like Citadel. In this context, alpha capture is like outsourced research, potentially offering access to more data and strategies than a fund can produce in-house:

• Bloomberg reported that the $67 billion Citadel, whose flagship Wellington fund gained 1.4% in April, will house the new alpha-capture initiative within its Global Quantitative Strategies business.
• Similar to other alpha-capture strategies, Citadel will collect trading signals on whether to go long or short on investments from fund managers with an established track record. 

Cashing In: Another way major hedge funds are utilizing the expertise of smaller peers is by simply handing them cash, outsourcing not just research but investing itself. Last week, Capula Investment Management reportedly backed smaller Cinctive Capital Management with $450 million. In March, prominent activist hedge fund Elliott Asset Management put roughly $100 million into the structured credit-focused hedge fund 37Spruce Investment Partners and, last fall, Brevan Howard invested $200 million in a healthcare fund run by Catalio Capital Management.