“We can see you’re a good analyst, but are you a money maker?” — Interview question.

Bets are integral to finance so it’s no surprise that business strategies in the industry should be launched by them. In 2001, Deutsche Bank’s former global head of equity trading and Mercury Asset Management’s former head of European equity investing disagreed on the worth of brokers’ stock recommendations. The pair, Ian Wace and Paul Marshall, had co-founded Marshall Wace, a London-based hedge fund, four years previously with seed capital from George Soros. Their focus was European equities and while they utilized the services of sell-side research for industry expertise, market color and so on, their views differed on how much value to place on analyst stock calls. 

To settle their disagreement, they tasked a summer intern to design a system to track the performance of recommendations. Initially, the goal was to reward institutions based on the profitability of their ideas, but the pair and their developer – who came on board as a full-time employee as soon as he graduated college – quickly realized that the system’s trade ideas could be optimized to try and outperform the market.

In July 2002, Marshall Wace began deploying capital from its flagship Eureka Fund in a portfolio of stocks determined by the system, now known as TOPS – “trade optimized portfolio system”. Its TOPS Opportunistic portfolio returned 23.9% gross of fees in its first full year, versus a market benchmark down 21.1%. Fifteen months later, the firm initiated a parallel TOPS Fundamental portfolio to invest in stocks over longer holding periods. 

By 2005, the system was drawing in 800 to 900 ideas a day in London. Rather than simply passively monitoring analyst recommendations, it asked brokers to submit them and weight them according to conviction levels, creating a more dynamic market in ideas. That year, TOPS elicited around half a million trading ideas from 2,200 individuals across 246 securities firms. Brokers were incentivised through commission payments, generously allocated according to performance. In 2004 and 2005, Marshall Wace is estimated to have paid brokerage firms over $250 million per year.

For research departments, the development came at an opportune time. In April 2003, as part of a Global Analyst Research Settlement, they had been forced to sever economic ties with investment banking departments so as to avoid conflicts of interest. Stripped of their share of revenues from corporate advisory mandates, directors of research were keen to foster alternative income sources. Marshall Wace helped fill the void. 

By itself, the idea was not new – although TOPS took it to new heights. Alfred Winslow Jones, credited as the inventor of the original “hedged fund” and described by New York magazine as the “big daddy” of the industry, pioneered the strategy in the early 1950s. According to Sebastian Mallaby, who writes about Jones in his book, More Money than God: Hedge Funds and the Making of the New Elite:

“[H]e invited brokers to run ‘model portfolios’ for his fund: Each man would select his favorite shorts and longs, and phone in changes as though he were running real money. Jones used these paper portfolios as a source of stock-picking ideas. His statistical methods, which separated the fruits of stock selection from the effect of market moves, allowed him to pinpoint each manager’s results precisely. Jones then compensated the brokers according to how well their suggestions worked. It was a marvelous technique for getting brokers to phone in hot ideas before they gave them to others.”

By the early 2000s, selective dissemination of research had been outlawed, so brokers could no longer front-run ideas the way they had for Jones. Instead, they leveraged their expertise across sectors and geographies, which Marshall Wace mobilized into an investment engine. Although initially some firms were nervous the system could encourage employees to skirt regulatory guidelines, rulemakers eventually gave it their seal of approval, arguing that the electronic audit trails it introduced reduced the risk of misconduct compared with traditional communication channels. 

Very quickly, Marshall Wace turned the system into a flywheel. “All TOPS is a Hoover,” Wace told the Wall Street Journal. “It sucks in great quantities of ideas and tries to sieve out what is interesting.” More ideas over a longer period of time led to a better calibrated sieve. A better sieve boosted the performance of TOPS funds. Stronger performance over a larger asset base generated more fees to pay for ideas. And so it spun. The system even incentivised participation at the individual as well as the institutional level: TOPS performance became a recognised industry benchmark that brokers could use to burnish their standing in the job market.

By October 2006, Marshall Wace was managing €3.9 billion in TOPS out of its total €5.9 billion assets under management. That month, it raised a further €1.5 billion by listing a closed-end fund, MW TOPS Limited, on the Amsterdam Stock Exchange.

Today, the firm runs around $30 billion across various TOPS funds. Like all profitable ideas in finance, it has also seen its innovation copied. Third-party providers of “alpha capture” software allow funds to plug into a network of idea generators without even having to recreate the Marshall Wace intern’s build-out. (The intern, by the way, was made a partner of Marshall Wace in 2004 and is now the firm’s third-largest owner. Institutional Investor magazine estimates that he personally made $330 million last year.)

Funds are also increasingly scraping other sources for ideas:

• Center books embedded inside multi-manager funds pull the best ideas from across a firm’s multiple investing desks into a central portfolio. As discussed in Peak Pod, the cost of sourcing these ideas is higher than from brokers – investment teams can be paid 15-20% of their performance – but the ideas are already captive to the firm, so the incremental margin is higher. 

• Newer firms, like Atom Investors and CenterBook Partners, capture ideas from other hedge fund firms in return for a share of performance fees. These funds market themselves as a solution for smaller firms to enjoy some of the advantages offered by multi-manager firms while retaining their independence. CenterBook currently curates ideas from 28 partner firms. 

• SumZero, an online platform where professional investors share investment ideas, is launching a capital vehicle to invest in stock calls posted on its site. “Our fund is driven by a quant model that leverages Natural Language Processing and Machine Learning technologies,” announced founder Divya Narendra (who worked with the Winklevoss twins in Harvard on the precursor to Facebook; he is played by Max Minghella in The Social Network). “Our model reads each new idea at the end of every day and then makes its investment decision.”

What each of these funds recognise is that idea selection is a different skill from portfolio construction (which is a different skill from running a firm). To see how firms reconcile the skills, read on.