When Prop Traders Turn Hedgie

by: Felix Salmon

Jenny Strasburg finds a couple of former in-house prop traders with new funds of their own: Arvind Raghunathan, formerly of Deutsche Bank; and Mark Carhart, who was at Goldman’s Global Alpha fund when it blew up. Both are pushing a quant strategy, although Raghunathan layers on top some outsourced fundamental analysis, with more than 50 researchers in Chennai poring over public filings.

The main question which Strasburg anticipates from potential investors is basically “why should I invest in you when your strategy blew up in 2007″. But more fundamentally, I just don’t see the attraction of prop traders setting up their own shop with huge investments from their former employer. I’d love to see some numbers on that: how often do such funds have huge success, and how often do they fail?

Anecdotally, banks have enormous difficulty replicating the success of their sell-side traders when they move those traders over to a buy-side structure. The reasons for this aren’t obvious, but I suspect that it’s because Chinese walls are always more porous than banks think they are, and that when you’re sitting on a big trading floor, or even just part of that business, you get a feel for short-term capital flows which is very hard to replicate at a much lower-volume hedge fund. This isn’t (necessarily) about privileged insider information, but ask yourself this: what would happen if a hedge fund manager asked to lease a desk on the Deutsche or Goldman trading floor, using none of the bank’s own money, but simply trying to monetize the advantage of just being physically in that place? It’s pretty obvious that the bank would say no immediately, no matter how high the offered lease payments were.

So in general I’m suspicious of hedge funds being set up by sell-side superstars: once they go buy-side, their hot streak has a tendency to come to a screeching halt. No matter how clever they are, or how unique their strategy is.