How do pod shops manage risk?

Factors, equity factor risk models, market neutrality: deep dive part 1

You might think that being a successful investor or Portfolio Manager, whether individually or as part of a firm, is all about picking good stocks - correctly identifying stocks that go up or down over a given period of time. In reality, that’s just one aspect of the job.

Portfolio construction and risk management are as important, or arguably even more important. And while these concepts can seem infinitely complex, they are also intuitive and not so complicated at the same time. So let’s try to understand them. We will start intuitively, without a ton of formulas or math, and delve into more nuanced concepts in later posts. In this post, we will explain the following in a very understandable way: factors, factor decomposition through equity factor risk models, market neutrality and hint at some of the optimization problems PMs face.

Why Understanding This Matters

You technically don’t need to know this as a junior analyst or at an interview, but you will be so much better off knowing it and can certainly make all the difference if you show at least some understanding of it. As an analyst at a multi-manager, you would make more meaningful contributions to your team’s book and make the transition to a senior analyst smoother. For people trying to break into the industry, showing an appreciation for it could be the difference between being hired or not.

The intuition isn’t that bad at all. Just stick with me.

You will also better understand why great software and technology are so important at any firm, making the barrier to entry in the industry extremely high and the appeal of a well-developed platform, support and infrastructure (e.g. Millennium, Citadel, Balyasny) as significant as ever. You might have heard a bunch of funds that are Millennium “platform companies”. Resources like software that aid portfolio and risk management are very expensive for firms to develop and maintain (just think about the number of software engineers Citadel hires and often pays them more than a tech company would). This, by the way, is why there are increasingly more companies building products for smaller or startup hedge funds.

Side note: Citadel, in particular, has been known for developing incredible tools and software for their PMs and was ahead of everybody else for years.