"Reuters Special Report: The algorithmic arms race"

From Reuters:

It's the day after Cambridge physicist Stephen Hawking's 70th birthday party and David Harding, the head of one of the most successful hedge funds in the world, is bubbling with talk of black holes.

Given the financial crisis of the last few years, some might see that as an unwise topic of conversation for a hedge fund manager. But for Harding, a physicist, the geekier the better.

The 50-year-old runs Winton Capital, one of a secretive but influential band of computer-driven hedge funds that bet tens of billions of dollars on the world's financial markets using algorithms - mathematical instructions to computers - which consume everything from bond price moves to rainfall statistics.

For Harding, whose business attracts mainstream pension investors from the world over, all of human knowledge is relevant. Rivals are circling, and data is becoming an increasingly strategic weapon.

Winton's collection of funds is now worth more than $29 billion. It has returned 14.8 percent a year in its main fund over the past decade - one of the best records over that period in the UK - and Harding is now likely to be Britain's highest-paid person, according to this year's Sunday Times Rich List. It says his wealth almost doubled last year to 800 million pounds ($1.27 billion).

Funds like his are known in the industry as trend-followers, managed futures funds or Commodity Trading Advisors (CTAs). Now run almost entirely by scientists, their 'black box' trading has entered popular culture: Robert Harris's latest thriller, "The Fear Index", features a fictional physics expert like Harding and rogue computer code.
But as algorithmic hedge funds have become better known and sucked in investors' money, returns have started to falter. Managed futures funds on average have lost money in two of the past three years, gaining just 4 percent in aggregate while the S&P 500 rose 49 percent. An investment in Winton's main fund would be down 0.75 percent in the first four months of this year.
The funds are struggling to cope with skittish markets. But they're also being squeezed by a more mundane fact: their basic techniques aren't so hard to copy, and can be worked out with a few internet searches.
That's started a fight for market share between big names such as Winton, Geneva-based BlueTrend and AHL, a giant fund co-founded by Harding before he set up on his own. To win, a fund needs two things: better data and smarter ways to use it.

"It's a bit like a war ... you have to keep on upgrading your armaments," said Philip Treleaven, a professor at University College London and head of its Financial Computing Centre, which works with some of the leading banks and fund managers. "You're looking for ever-newer algorithms and so you're using broader sets of data and non-traditional data."

TURTLE RETURNS
To see how trend-followers aren't all about rocket science, take one of the forefathers of today's fund managers: Chicago-based trader Richard Dennis. In the 1980s, he made a bet with a rival that successful traders could be taught, that it wasn't an innate talent.

As part of the contest, Dennis taught a breed of traders he called 'Turtles' because he trained them to lock into specific market trends and ride them, just as turtles ride sea currents. What was important was to decide on a system and stick with it.

The approach lends itself to computerized dealing, because in it, trades are often triggered by the dynamics of the market itself. A classic example is the moving average. Track the five-day moving average of a stock and, some traders believe, you should buy where it crosses above the 30-day average or sell when it falls below.

Such ideas can be converted into an algorithm that tells a computer when and how to trade.
The turtles' edge, like trend-followers today, was in exploiting the reality that mainstream economic theory doesn't allow for: financial markets don't behave efficiently, but follow vogues and panics....MUCH MORE