This content is from: Corner Office
Inside the Geeky, Quirky, and Wildly Successful World of Quant Shop Two Sigma
Co-founders David Siegel and John Overdeck have earned Institutional Investor’s Lifetime Achievement Award for hedge fund management this year. Paul Tudor Jones and Tom Hill dish on the $60 billion quant powerhouse’s early days.
The first time hedge fund legend Paul Tudor Jones met quant maven John Overdeck was over a greasy meal of cut-price pepperoni pizza. It was January 2001, and the two were dining at the Pizza Hut in Greenwich, Connecticut — “my Sunday evening go-to restaurant,” according to Jones — to discuss a business plan for a new quantitatively driven hedge fund firm.
David Siegel, then the chief technology officer of Jones’s firm, Tudor Investment Corp., and Tudor president Mark Dalton had been hashing out the plan with Overdeck, then an executive at Amazon.
“I could tell you that I went to Pizza Hut with an HP12C hidden in my pocket for an on-the-spot calculus challenge, but I knew I would lose — even with the HP,” Jones recalls in an email interview with Institutional Investor. “The lights flickered for an hour on my pepperoni off John’s brain waves.”
Jones came away from the encounter feeling that John was “an intellectual twin of David and the ideal co–founding partner” for the venture.
Overdeck left the meeting with a seed investor: Jones decided to back the new firm, Two Sigma, which was officially launched later that year by Overdeck, Siegel, and Tudor chief financial officer Mark Pickard (who retired in 2006).
“It was pretty obvious the combination was going to be a world beater,” Jones recalls. “John and David have intellectual horsepower, the ability to recruit outstanding people, and a rigorous and foresighted scientific and technology-driven approach to data analytics and building trading strategies. Together this mix gave us high confidence.”
Not everyone was quite so sure. J. Tomilson Hill, who was running the then-nascent Blackstone Alternative Asset Management, recalls meeting Overdeck and Siegel in his conference room at 345 Park Avenue in New York at about the same time to discuss possibly investing in Two Sigma. He knew the pair from their days working at quant pioneer D.E. Shaw, in which Blackstone was a large investor.
“Even though we knew what Renaissance [Technologies] and Shaw were doing, as systematic investing was becoming more prevalent, we had a lot of questions — not just about their data science capabilities, but how they execute trades,” admits Hill, who retired as chairman of BAAM at the end of 2018 and is now a consultant to Two Sigma. “Cost is a big deal — the high frequency of transactions, speed."
Hill knew Blackstone would never have access to the algorithms. But he recalls being reassured by the founders, as well as the firm’s culture, processes, and risk management capabilities. “We quickly became convinced Two Sigma had something special,” he says. “At the end of the day, though, we had to take a leap of faith.”
Jones and Hill could not have known how well those early bets would turn out. Today Two Sigma Investments manages about $60 billion, making it one of the world’s largest hedge fund firms. It employs some 1,600 people — two thirds of whom are in research and development roles, mostly with science and math backgrounds, including about 250 people with Ph.D.s. And its turnover is at a single-digit percentage rate.
The firm can thank strong performance for its remarkable growth. Since its inception the Two Sigma fund, the firm’s first fund, has compounded at a double-digit percentage rate, on average, and the funds in aggregate have been profitable every year.
In 2018 alone the firm generated $3.2 billion in net gains for its investors, the third-highest amount among all hedge fund firms — behind only quant-driven rivals Bridgewater Associates and Renaissance — according to an annual analysis by London-based LCH Investments. Since the start, Two Sigma has generated $15.2 billion in net gains, ranking No. 19 among all hedge fund firms, most of which were launched years before Two Sigma.
For their role in creating Two Sigma, and their role in advancing quantitative investing, Siegel, 57, and Overdeck, 49, are this year’s recipients of Institutional Investor’s Hedge Fund Lifetime Achievement Award. The pair declined to comment for this story, partly because they steadfastly believe that Two Sigma’s success is a firmwide effort. Jones agrees.
“Two Sigma sets a continuing high bar for standards in building a technology firm that is reinventing investment management,” says Jones, who stresses that in just 18 years, the firm has moved from boutique to institutional asset manager operating on a large scale. “Their approach is scientific and relies on taking intellectual capital across markets, products, and processes.”
Another early investor, however, maintains that Siegel and Overdeck deserve credit for laying the groundwork.
“The reality is that most people who set out to do quantitative investing fail,” says hedge fund industry pioneer and Paloma Partners founder Donald Sussman, who seeded D.E. Shaw and was an initial investor in Two Sigma. “The ones who succeed are the exception. What they created is spectacular.”
Growing up, Siegel and Overdeck seemed destined for high-tech careers. Both were science prodigies.
In his official biography on Two Sigma’s website, Siegel says he was inspired by movies such as 2001: A Space Odyssey and was drawn to the new and growing field of computer science at a young age. When he was 12 he was building memory and logic boards and learned to program a supercomputer at New York University’s Courant Institute of Mathematical Sciences. As a high school freshman, he taught a computer programming course for high school students in an NYU summer program.
Overdeck earned a BS in mathematics (with distinction) and an MS in statistics from Stanford University. A math prodigy, at age 16 he won a silver medal for the U.S. in the 1986 International Mathematical Olympiad in Poland. He came by his talent honestly: His father was a senior mathematician at the National Security Agency, and his mother directed satellite communications software development for Computer Sciences Corp.
Siegel, an artificial intelligence specialist, launched his Wall Street career at D.E. Shaw after receiving a Ph.D. in computer science from the Massachusetts Institute of Technology, where he conducted research at the Artificial Intelligence Laboratory. At Shaw, Siegel founded FarSight Financial Services, the first integrated personal financial services website, subsequently acquired by Merrill Lynch & Co. He then became chief technology officer at Tudor Investment.
Jones jokes that Siegel’s idea of fun was going to Tokyo’s Akihabara district for the latest in tech gadgets. “I’m told it’s the tech equivalent of the Diamond District, rows of vendors from one-man stalls to megaretailers,” he says. “So — circa late 1990s — David was there, probably seeking out a PalmPilot or maybe a satellite phone the size of a small rhino.”
But Siegel was no ordinary tech geek. Jones describes Siegel, who worked for him for four years, as “a thinker, a doer, a business builder,” and lauds his ability at the time to recruit and organize human talent to build the infrastructure needed to support Tudor’s trading business over the next ten years.
“He also knew how to build adaptable software that worked across that infrastructure in all units of Tudor’s growing business,” Jones adds. “When he completed that rebuilding in a brisk few years, he proposed a business plan with Tudor ultimately to build a stand-alone quant trading firm.”
Overdeck began his career at D.E. Shaw, eventually directing the firm’s Japanese equity and equity-linked investments, and oversaw its investment management affiliate in London. He left the firm to serve as vice president and technical assistant to Amazon.com founder Jeff Bezos before launching Two Sigma.
“In the 1990s [John was] one of the top mathematical modelers and minds in the financial markets while at D.E. Shaw,” Jones notes.
When Siegel and Overdeck launched Two Sigma, quantitative investing was sort of a niche neighborhood in the hedge fund world, populated by few firms other than Shaw and Jim Simons’ Renaissance, which at the time managed $3 billion and less than $6 billion, respectively.
The world was becoming increasingly interconnected, however. The internet had already been widely used for a few years by then, electronic trading was taking off, and the globalization of companies was exploding. In 2001 the Securities and Exchange Commission ordered all stock markets to price shares in decimals rather than fractions, which made pricing even more precise. And Moore’s Law — which posits that a certain measure of computing power will double roughly every two years — was seemingly accelerating. All of these movements factored into Siegel and Overdeck’s vision.
Like Shaw and Renaissance, Two Sigma was set up more like a technology company than a financial services firm. It hired people with master’s degrees in data science, not MBAs, an unusual move at the time but one that has now been embraced by even the so-called fundamentally driven investment firms, which depend on humans for most of their investment decisions. Two Sigma aimed to be a technology and engineering firm competing with the likes of fledgling internet titans like Google and Amazon and not Wall Street giants like Goldman Sachs.
On its website, Two Sigma says the founders believe that innovative technology and data science can help discover value in the world’s data.
“We follow principles of technology and innovation as much as principles of investment management,” the site explains. “Fields like machine learning and distributed computing guide us. Since 2001 we’ve searched for ways that these kinds of technologies can make us better at what we do.”
Two Sigma reinforces this culture by encouraging its employees to branch out from their daily work. For example, it conducts engineering and coding competitions. In 2016, teams of employees built an automated air hockey machine to compete against human players. In May of this year, a Two Sigma team competed in the inaugural New York City FIRST robotics corporate challenge. (New York City FIRST, co-founded by Siegel, is the New York chapter of For Inspiration and Recognition of Science and Technology. Siegel sits on the national board.) The firm set up a temporary robotics lab in its offices and built a robot capable of completing a series of tasks in an “arena.”
“Two Sigma is a technology company in the alternative industry, with all that implies —specifically, hiring and managing scientists, engineers, and academics to seek connections in the global markets,” notes Jones, who quips, “I think it also means that you can get a vegan lunch on the trading floor.”
Though market observers might track the rise and twists of a long-short manager by setting its performance against that of the S&P 500 or other stock indices, Two Sigma’s ascendance more closely tracks the expansion of computing power and the acceleration of data.
Two Sigma has seven absolute-return groups of funds that fall into two general types: equity market-neutral and various macro strategies. It rolls out its hundreds of models in four broad categories.
One emphasizes a company’s fundamentals, such as financial statements. The technical category looks primarily at exchange-related data like pricing, volume, and momentum, to cite just a few factors. A third category examines events like earnings announcements, as well as non-scheduled events such as mergers and acquisitions. And alpha capture, the fourth category, solicits information from Wall Street's sell-side salespeople in a systematic way.
The Two Sigma fund, launched in April 2002, was designed as a market-neutral fund with a fairly high turnover strategy, plying the most data-rich and liquid markets. The platform was built to work well for U.S. equities but was flexible enough to be extended to European and Asian stocks, futures, and foreign exchange. The idea was to always have one platform that could be expanded. The fund enjoyed instant success, rising by double digits in the first stub year as well as in its first full year (2003), at the same time that most market indices were getting battered amid the dotcom bust.
Two Sigma’s first asset class expansion came in 2004 when it launched Eclipse, introducing macro into the strategy mix, which included futures and foreign exchange.
In 2004 the firm also started Spectrum, the first time it had designed a fund for a longer holding period. This fund formed the basis for product expansion and cleared a pathway to a more scalable asset management business. Two Sigma then launched Absolute Return in 2011, which had a longer holding period.
All along, technology was evolving. Two Sigma, of course, had always had a data science and technology focus. It was an early adapter of many important tools, such as machine learning and artificial intelligence, while being aware of their limitations.
“Two Sigma has world-class computing power that would rank the firm among the top supercomputing sites in the world,” said hedge fund consulting firm Aksia in an October 2016 Manager Recommendation Memo to the board of trustees of the Pennsylvania Public School Employees’ Retirement System recommending it invest in a new Two Sigma fund. “This computing power is used to gather, clean, analyze, and warehouse large amounts of data from external sources.”
But even top-notch technology didn’t keep the firm from encountering a rough patch on its way to $60 billion.
One of Two Sigma’s most challenging periods began in 2007, when stocks plummeted in August during what has been called the quant crisis — which was sparked by a series of high-profile events, including the collapse of two Bear Stearns credit funds, and served as a canary in the coal mine of the financial crisis.
“The losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios,” stated an MIT paper published the following month. Two Sigma, however, managed to finish the year in the black.
In 2008, the year of the financial crisis, Two Sigma’s funds finished in the high single digits while most hedge funds lost money, many by double-digit percentage rates.
“When the markets were stressed, we were counting on Two Sigma to bring their risk management capabilities into effective play,” recalls Hill. “They never disappointed us in terms of risk management.”
Like other hedge funds that made money that year, however, Two Sigma paid a heavy price, suffering a rash of redemptions from liquidity-seeking investors who were unable to pull their money from the many troubled funds that suspended redemptions that year. Altogether, 30 to 40 percent of Two Sigma’s assets were cashed out.
That experience taught the firm to target different clients. In its first six to seven years, Two Sigma managed money for the traditional hedge fund investor base — wealthy individuals, family offices, and funds of funds. After the financial crisis it intentionally shifted its focus to emphasize institutional investors: pensions, sovereign wealth funds, endowments, and the like. It then designed and launched new strategies to meet those clients’ needs, off the same research platform.
Two Sigma has also continually evolved in many other ways. For example, it has expanded its distribution channels. Since 2014 it has had at least one fund in the Blackstone Alternative Multi-Strategy Fund, a liquid alternative fund of funds, which is a mutual fund restricted to high-net-worth individuals. In 2016 it teamed up with Luxembourg-based Schroder Investment Management to offer a UCITS (undertakings for the collective investment of transferable securities) fund, Europe’s version of a liquid alt mutual fund.
Two Sigma also launched a risk premia fund, a lower-cost offering that expands on the firm’s existing platform.
Today Two Sigma takes a more conservative attitude toward growth. Most of its hedge fund strategies are closed to investors. But it is expanding in other ways.
In November 2018, Two Sigma received its Wholly Foreign-Owned Enterprise (WFOE) license in China and is currently applying for a Private Funds Management license, which will allow it to raise an onshore fund in China.
In recent years the firm has also launched Two Sigma Ventures, which invests in early-stage companies using data science, machine learning, distributed computing, and advanced hardware across a range of industries, and Sightway Capital, a private equity business focused on middle-market growth equity investing in financial services and real assets. Two Sigma Securities is a broker-dealer and a registered market maker in more than 8,000 U.S. exchange–listed equities, facilitating the execution of more than 300 million shares per day.
In 2013 principals of Two Sigma partnered with insurance industry veteran and current American International Group chief executive Brian Duperreault to purchase reinsurance company SAC Re, which was then renamed Hamilton Re. In 2016, Hamilton Insurance Group and Two Sigma teamed up with AIG to create Attune, a technology-driven platform, to serve the U.S. small to medium-size commercial insurance market.
Separately, Two Sigma Insurance Quantified brings the company’s data science discipline to insurance. TSIQ built datacentric, cloud-native software and has already delivered a first version to AIG, its anchor client.
Overdeck and Siegel have also expanded their philanthropic presence. The Overdeck Family Foundation, chaired by John Overdeck’s wife, Laura Overdeck, provides educational opportunities focusing on early childhood, educators, out-of-school STEM (science, technology, engineering, and math) activities, and the use of data.
The Siegel Family Endowment supports organizations that are helping to prepare society for the impact of technology, with funding for organizations including Scratch — which teaches kids computational thinking skills through coding — and efforts like Data & Society, a research institute that examines the social issues that can arise from pervasive technology.
Two Sigma, Siegel, and the Siegel endowment have all supported FIRST, an education charity in New York City that encourages students to get engaged in science and technology projects.
Says Jones: “I have marveled at watching David and John come into their own as philanthropists, sharing their success with those in need through their family foundations, as well as with their time and ideas.”