Wealth

Citadel Soars: How Ken Griffin Built a Financial Powerhouse

The premier hedge fund of 2022 emerges as Citadel Investments helmed by Ken Griffin. Its financial prowess is indeed illustrious:

1. Accumulating net profits amounting to a staggering US$16 billion for its clientele.

2. Garnering nearly $12 billion through management fees and profit sharing.

3. The flagship fund boasts an impressive yield rate of 38.1%.

Annually, there arise triumphant figures in the realm of finance akin to ‘casinos’, where fortune often favors even those deemed as prodigies.

Take, for instance, the precedent set by John Paulson, dubbed the “Wall Street Air God,” who amassed a record-breaking US$15.6 billion during the iconic “Big Short” confrontation of 2007.

Elevated to a deity-like status, Paulson ventured into gold investments, reaping an additional $5 billion in profits.

However, from 2011 onwards, this ‘Great God’ witnessed a decline in fortunes. His funds suffered continual setbacks, dwindling from a zenith of US$38 billion to a mere fraction.

This narrative resonates with the Western adage from “The Ballad of Buster Scruggs”:

“A pretentious fast shooter, vanquished by a swifter gun.”

In contrast, Ken Griffin’s trajectory appears distinct.

The scion of a construction supplier, Griffin’s formative years were imbued with a fervent curiosity for unraveling the mysteries of the world. He honed his skills in computer programming during the 1980s while in high school.

During his tenure at Harvard, Griffin delved into the intricacies of convertible bond arbitrage. Employing bespoke software, he scoured for undervalued bonds and installed a satellite dish atop his dormitory to facilitate his endeavors.

Griffin’s modus operandi entailed acquiring underpriced warrants while hedging against them through shorting corresponding stocks—a strategy reminiscent of Edward Thorpe’s “delta hedging strategy.”

Thorpe, whilst at MIT around 1960, unearthed a fractional advantage in blackjack, thus inaugurating a paradigm shift wherein the casino’s statistical edge metamorphosed into an avenue for probabilistic exploitation.

However, mere advantage alone proved insufficient.

Confronted with the inexhaustible resources of the casino, Thorpe sought guidance from Claude Shannon, the progenitor of information theory. Leveraging Kelly’s formula, they devised a method to circumvent the limitations posed by finite resources against an infinite adversary.

Thus, a nascent advantage, hitherto concealed, burgeoned into a blueprint for wealth accumulation.

Incidentally, Shannon himself enjoyed considerable success in stock investments.

Thorpe’s odyssey heralded the dawn of prosperity for savants:

Mastering chance and bargaining with the deity of affluence.

Transitioning from casinos to financial markets, Thorpe persisted in decoding the cryptogram of prosperity amidst chaos. Identifying overpriced warrants as fertile ground, Thorpe espoused the practice of short-selling as a lucrative enterprise.

However, cognizant of the capricious nature of markets, Thorpe refrained from relying solely on prescience. The capricious nature of human desires and actions, akin to George Soros’s concept of “reflexivity,” posed an ever-looming enigma.

Thorpe’s stratagem embodied the essence of “arbitrage”:

Vendoring overvalued warrants while procuring stocks as a hedge.

Therein lies an axiom of Wall Street: “Bestow a fish for sustenance today; impart the wisdom of arbitrage for a lifetime’s sustenance.”

I wish to annotate my “two-eyed theory” with pertinent illustrations:

1. Thorpe’s dual methodologies to outmaneuver the casino in blackjack—the “Law of Large Numbers” and the “Kelly Formula.”

2. Griffin’s foray into convertible bond arbitrage epitomizes the symbiosis of two perspectives.

Commencing his venture into convertible bond arbitrage at the tender age of 18, Griffin founded Citadel at 22 with an initial endowment of US$4.2 million.

In essence, Griffin inherited the legacy of Thorpe and Shannon, melding mathematics, computational prowess, and financial acumen with the voracity of Wall Street, the tenacity of a predator, and the vision of an entrepreneur, thus birthing a financial empire.

Griffin’s Citadel encompasses two ventures:

One, akin to prospecting for gold, embodies Citadel Hedge Fund, boasting a colossal capitalization nearing US$53 billion and potentially heralding the most lucrative hedge fund in history.

Over the past three decades, Citadel has furnished investors with an annualized return hovering around 20%, enduring only two periods of contraction, albeit one notably severe.

The other facet, Citadel Securities, epitomizes a purveyor of liquidity—a pivotal market maker on a global scale and the foremost options market maker in the United States. Commanding nearly a quarter of the options market on U.S. listed stocks, Citadel Securities garners revenue primarily from the “crumbs” of bid-ask spreads.

Though minuscule in isolation, these crumbs amalgamate into a river of revenue facilitated by the alchemy of automation and market flow.

In 2022 alone, Citadel Securities recorded revenues amounting to $7.5 billion.

Amidst the skirmishes of retail investors and short sellers in 2021, Citadel Securities facilitated the lion’s share of trades on Robinhood, employing the contentious “pay for order flow” model.

Notably, Melvin Capital, nearly vanquished by retail investors, received a lifeline in the form of a $2 billion investment from Citadel Hedge Fund.

Thus, while one hand delves for gold, the other peddles water.

As one of the vanguards of quantitative finance, Griffin eschewed the pursuit of deification as a stock market luminary. Instead, he architected Citadel into a multifaceted entity—a bastion of financial prowess and a haven for aspiring magnates.

Opting not to be the paragon of chance, but rather the architect of fortune;

Abandoning the race to be the swiftest shooter, in favor of fostering an ecosystem fertile for those who are.

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In summary, Griffin’s Citadel uses a diversified investment strategy, as well as a horse racing mechanism with multiple portfolio managers.

As a multi-strategy hedge fund, Citadel covers equity, global fixed income and macro, commodities, credit, and quantitative strategies.

In a world increasingly filled with uncertainty, especially during the past few years of the pandemic, diversified strategies appear to be better able to cope with fluctuations and hedge risks.

A single strategy looks thin in comparison.

For example, Tiger Global lost 54% in 2022.

Several well-known hedge funds, known as the “Little Tiger Team”, also encountered difficulties due to similar investment strategies, such as buying large amounts of growth stocks.

The talent mechanism of diversification and horse racing also seems to be conducive to risk diversification.

Citadel’s operating model is a multi-manager platform system:

1. The company has many portfolio managers, each of whom recruits several researchers to form a small team to manage part of the company’s funds;

2. Each team operates independently, and the fittest survive according to indicators such as income;

3. As a large platform, Citadel provides backend support for the team. It’s kind of like the G.I. Ops model.

Obviously, this model is inseparable from powerful back-end systems and technical support, and also requires a unique corporate culture.

This is quite similar to hedge fund Millennium, which also has a quantitative background:

“Millennium adopts the management structure of the MOM platform, which means finding the best fund managers, forming a team, and allocating funds. There are no restrictions on personal investment styles, and everything is based on performance. The underlying resources are shared to give full play to the power of the platform.”

There are more than 270 “gunners” in Millennium 2021. They are assessed every six months, and the elimination rate is extremely high. At the same time, new “gunners” will be added quickly.

Griffin once talked about his attitude towards talent and technology. He believed:

Balancing the “tidal wave of new technologies” and the “power of the human mind” is critical for better decision-making inside and outside financial markets.

To put it simply, it is “human-machine integration”.

If Amazon or Meituan combine technology platforms with terminal labor, then Citadel is trying to combine technology platforms with decision-making talents.

I saw this paragraph on Harvard University’s website:

“The competitive advantage Citadel aspires to comes from being able to use technology, machine learning and human capital to accumulate all available public data and then “extract the most relevant information and then be able to interpret that data correctly.” ”

Citadel uses machine learning in a variety of ways, primarily to help predict metrics like same-store sales, identify risks in a portfolio, and generate ideas.

However, Citadel’s machine learning is used to aid human judgment, not replace it. ”

In addition, the company will use technology and financial means to allow portfolio managers to realize their fleeting genius ideas of betting against the “God of Gamblers” within set and monitored risk limits.

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Griffin’s fund company was called the Google of finance in the early years, and later people said that he was Musk of finance.

Indeed, like Page and Musk, Griffin uses technology and talent to reshape his field. ‍‍

There is nothing more important than bringing together a group of extremely smart professionals. ‍‍‍‍

There are two impressive stories.

Story 1: At the beginning of the epidemic in 2020, Citadel Securities moved more than 1,000 servers and some traders from New York and Chicago to the Four Seasons Hotel in Palm Beach, Florida.

When the country went into lockdown, Griffin’s core staff of 50 worked from the Four Seasons every day.

Story 2: In December 2022, Griffin also spent his own money to invite approximately 10,000 employees and their families to gather at Disneyland in Florida for a three-day celebration at the Magic Kingdom and other theme parks.

On the homepage of Citadel’s official website, it lists the company’s various Olympic medal winners, various PhDs, various engineers, various financial professionals and quantitative talents, etc., and declares:

We bring together brilliant minds to do things others think are impossible.

Former Goldman Sachs CEO Lloyd Blankfein once praised his friend Griffin:

“He’s a great trader, but he’s also a great businessman, and those things don’t usually go together. It’s like a runner who wins both the 100-meter dash and the marathon.”

Usually, traders are like lone wolves and need to be ruthless and cruel; while businessmen need to gather resources and people.

Investors always hope to beat the market in the long term.

To achieve this is like fighting gravity.

A man cannot pull his hair off the face of the earth, but a machine can.

As a machine, enterprises also fight against “entropy increase”, against the “efficient market theory”, against the life cycle, and against the random dominance of the God of Wealth.

And in this machine, the most important thing is still one of the most mysterious things in the universe:

human brain.

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Einstein may not have imagined that his research on Brownian motion would be so closely related to money.

Five years earlier than him, in 1900, the lonely Louis Bachelier studied Brownian motion and the randomness of stock price changes from the perspective of stochastic processes, and proposed a concept that the world could not understand in the following decades:

The discounted value of past, present, and even future events is reflected in market prices.

Stock prices follow a fair game model.

In 1956, physicist Osborne improved Bachelier’s Brownian motion model into a geometric Brownian motion model.

In 1964, Fama used the random walk model to describe stock price changes and proposed the famous efficient market hypothesis.

In 1965, Samuelson added a linear drift term to the geometric Brownian motion model and established a geometric Brownian motion model with drift, thus explaining the long-term linear trend of stock prices.

In 1970, Black and Scholes derived the famous B-S option pricing formula, using mathematical tools to solve the problem of reasonable pricing of financial derivatives such as stocks, bonds, currencies, and commodities.

Around the same time, Thorp used almost a similar method to calculate option values ​​to achieve arbitrage between stocks and options. ‍‍‍

In 1990, when Griffin was just starting out, Thorpe gave him prospectuses for some of his past convertible bonds and warrants, and the young man was lucky that he didn’t have to explore the gold mines from scratch.

While smart traders regard the B-S option pricing formula as a basic tool, they do everything possible to make themselves the sharks who fall in love with and kill each other with the “efficient market hypothesis”:

Sharks make the market efficient by hunting rich food.
This also seems to be arbitrage: an arbitrage between what works and what is about to work.

“The efficient market theory is true 4/5 of the time, and investors can take advantage of the remaining 1/5 opportunities.”

The B-S option pricing formula is like Newton’s law. The efficient market hypothesis is like “gravity”, dragging all the geniuses who try to use their intelligence to strangle those who are not as smart as themselves in the market back to the ground.

Even Buffett, who is most troubled by the “efficient market hypothesis” theory, although he has beaten the S&P 500 for many years in a row and has ridiculed professors who study formulas and theories more than once, he still stands on the side of “it is difficult to beat the index.”

Buffett made the bet of the century when he bought Vanguard’s S&P 500 Index Fund in 2007, while his opponent selected five hedge funds.

Buffett’s “horse racing” lost 37% in the first year (2008), while his opponent lost 23.9%.

Ten years later, Buffett is still winning. The “boring index” once again outperformed hedge funds handpicked by professionals and run by top smart people.

A rational person would defend his or her views, but would not refuse to hedge by betting in the opposite direction.

Just like Samuelson, who firmly believes that “markets are efficient”, he also bought shares of Buffett’s company that “do not conform to his own theory”.

Although Griffin, like Buffett, will take action when his large prey is in trouble. However, he doesn’t seem to care about a stock’s fundamentals or intrinsic value, only about price fluctuations.

Indeed, from the beginning, like Thorpe, he made money through arbitrage rather than being a “faster shooter.”

Economist Robert Shiller pointed out in his book “Irrational Exuberance”:

“We should remember that stock market pricing is not a perfect science.”
Unlike the random walk of Brownian motion studied by Einstein, the human world of money is intertwined with too many complex elements.

The bell curve cannot cover all uncertain factors, desires, leverage, herding effect, and fat tails, causing black swan events to occur frequently, giving people a fatal blow.

Taleb believes that “the validity of mathematical finance theory is as unreliable as astrology” and accuses mathematical finance of “consistently putting the financial system at risk of collapse.”

Griffin’s Citadel also suffered significant losses in 2008. He later reflected:

Difficulties arise in part from overconfidence, a belief in one’s ability to weather any market disaster.

Desire will never stop, and people can’t help but gamble with the “God of Wealth”, even if the randomness is like God’s ridicule and teasing.

To achieve excess returns, smart people use various methods plus leverage:

Gamblers like to leverage their money without limit;

Value investors add long-term time leverage;

Quantitative traders use high-frequency leverage.

Griffin de-leveraged his early years. On the one hand, he increased the leverage of technology, and on the other hand, through organizational innovation and talent strategy, he realized the leverage of distributed smart brains, making his arbitrage game bigger and bigger.

He has come a long way, how much longer can he go in the future?

If Buffett still had time to make a ten-year bet with Griffin, who would win?

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