Citadel CEO Ken Griffin on Hedge Funds, Financial Regulation

I'd like to begin our conversation. Your industry is under pressure. Hedge funds are closing at the fastest pace since the financial crisis, as you know, and those funds that survive are, in many cases, retrenching. They are pulling in or even returning money to investors.

What's going on? How do you see it? Well, I've been in this space for almost 30 years now, and over the 30 years, there's just been an explosion in the size of the industry, the number of funds, $3 trillion of capital now deployed in hedge funds. It has been an unbelievable growth story. And like many growth stories, we're going through a period of retrenchment as the dynamics of the playing field are changing. It's harder to create alpha today, there's more competition, there's a lot of very sharp people trying to find opportunities in the marketplace. This is causing some of the second-tier players to fall by the wayside. We saw the same retrenchment in the dot-com bust, where you see second-tier firms that don't have a competitive advantage,

eventually have to call it a day and move on. Why is it so hard to generate excess return? Well, remember, your excess returns come from market inefficiencies, and the work that everyone has done over the last 30 years to commoditize news, data, and information means that our markets today are much more efficient in the short run. Is there less alpha to be had? Well, because the markets are more efficient, there's less alpha to be had. So think about a company announcing earnings. Today, those earnings will be analyzed. People will have preemptively decided, if a company's going to announce this, here's what we're going to do, so that literally within seconds of the earnings announcement, you're already seeing the stock price move and adjust to where it should be to reflect all the news that we have.

Now take an inter-quarter period where you're looking at that data that comes from consumer credit cards, for example, giving you insights into how the quarter's evolving. All these dynamics are making the markets more efficient, more fair, but for the industry, for all active managers, it's reducing the amount of alpha that's available to us as a community.

Is your position, would you describe it as offensive or defensive right now? It's offense.

Offense in what way? Offense in the quest for talent. There are a number of really talented individuals that we can hire and bring onto our team in this environment. With firms shutting down, there's a lot of good people that we want to bring into Citadel. And when firms are struggling, there's a chance for us to bring good people into Citadel. Citadel's been built on one simple equation, a belief that super-talented individuals working together as a team can create extraordinary results.

What strategies, investment strategies, or approaches do you believe will be most successful in this environment, the one you just described, and the way you see markets evolving?

So what I find works well over time is having a deep expertise in the area in which you're participating. I always think about investors that run a big US book and they go buy a stock in Brazil as being like drive-by or tourist investors. That investment in Brazil is almost certainly not going to work. They don't understand the company, the country, the pricing dynamics, what's relevant. So for us, the core belief that we have is that deep expertise is rewarded. So we organize our firm where people specialize. They're a healthcare expert. They're an expert in industrial stocks. They're specialists in pricing natural gas across Europe. It's that deep specialization that we think drives differentiated and superior returns.

And of the stuff that you do, what's working well? And what do you think will continue to work well?

If I look over the last three or four years, we've been successful across the vast majority of our strategies. And I think it comes back again to individuals with a deep degree of expertise and specialization who work as part of a team. Teams are really important today to gather the mosaic of information that you need to have an insight different from your competition. That teamwork dynamic is really important, and then they're well supported by great quantitative analytics, great decision support systems. How long do you think it's going to take before this shakeout in the hedge fund industry is over, and by the time it is over, what will have happened? Well, I think it's not just a shakeout for the hedge fund industry; it's a shakeout for active management.

Right. We see the rise of passive money in ETFs and index products. We're seeing money come out of active management and head towards passive structures. Now, as that happens, the money that's in passive structures obviously is not pursuing alpha in the same way. That should make the markets a little less efficient, which should create a larger profit pool for those who remain. So we're gonna find a new equilibrium over the months and years to come. Passive's gonna be bigger, active's gonna be smaller, and the firms that are best able to assemble, analyze, and incorporate information in their investment decision-making processes are going to continue to earn outsized returns.

How large do you believe the opportunity set in billions of dollars is for Citadel?

In terms of how much capital we can manage? Yes. You know, I don't fixate on that problem. I fixate on...

I'm not suggesting you do; I'm just curious.

No, I'm just answering. And, you know, can we manage $25 billion? We do manage $25 billion. 35 is probably outside our reach right now. If I look at what drives the success of our teams, And there's both a analytical element and a psychological element that come to play as you grow. Imagine you're a portfolio manager in a hedge fund. And you're accustomed to having days where you make three million dollars or lose two million dollars or make four million dollars. If I say I'm going to give you three times as much money, your worst days now are three times worse. And when that number all of a sudden is you lost 10 or 15 or 20 million dollars in a day, psychologically a lot of people have a hard time with that.

So when we think about growing our business, it's about growing our capabilities and our competitive advantages, and then it's helping people deal with the psychological impact of taking more risk and, when you're wrong, being wrong in a meaningful way. And that's hard for people to deal with. We're all human.

Ken, Citadel is notable for the speed and conviction with which it has responded to changes in market regulation and structure. You've built a huge business in equities execution, and more recently in fixed income, you filled the void left behind by banks in market making. What about the approach the new administration is taking on regulation interests—or perhaps concerns—you?

It's way too early to tell. First of all, at 100,000 feet, the move to reduce regulation in the United States, I applaud. This is the single greatest lever they can pull to get our economy to go faster. I mean, if you recall, I started my business when I was in the dorm room at Harvard. $265,000, and I could launch a hedge fund in 1987. You can't launch a hedge fund today with less than several hundred million dollars, given the high fixed costs of compliance and other regulatory matters that you need to deal with. So that's really discouraged new business formation in asset management. It's just the burdens of regulation. Take this outside of asset management: the energy space, the transportation space...

It's everywhere in America, the weight of regulations reducing new business formation in America. And that is a tragedy. So the administration's focus on reducing the regulatory burden on the American who has a dream. I applaud that vision.

The last administration was very interested in introducing more transparency to the bond market. What about this administration?

I really hope they follow through on that. Why? Transparency is what creates confidence. Confidence that you've been treated fairly, confidence that you understand what's taking place in a marketplace. Transparency is the underpinning of a healthy capital market. Now, in a market that's opaque, the incumbents enjoy the information advantage of that opacity. But that doesn't make for a good market. So if this administration continues to carry that baton forward and shine light on how Treasuries are priced and traded, that would be really good for the entire marketplace. And if they don't? If they don't, I think it's unfortunate. And in particular, when the bills that we are looking at, whether it's the reform for Obamacare, the tax bill, the infrastructure bill,

We're taking our deficit higher. And I think it's really important that we take steps to continue to drive the U.S. fixed-income market, the U.S. Treasury market, to be perceived as the most liquid, fairest market in the world. That will drive down the cost of borrowing, which will benefit and save money for every American taxpayer.

Ken, just today President Trump told my colleagues in Washington that he is taking a serious look right now at steps to break up the big banks.

Would you be in favor of that? I would. I believe that when a market becomes overly concentrated, you reduce competition. And competition is the lifeblood of what makes a free economy work. When you have many firms that are vigorously competing to get ahead, that's when creativity happens, it's when innovation takes place, and it's when consumers win. In the financial crisis of '08, a number of decisions were made very quickly that resulted in a massive consolidation of the U.S. banking system. I don't think that serves the interests of our country well. Now, would I argue to break these banks into many, many small banks? No. But should we think about separating the investment banks from the core commercial banks?

A new Glass-Steagall, if you will.

A new Glass-Steagall? I would be really excited to see that. You think it would be good for the economy? Oh, I think it would be great for the economy. Would it be good for your firm as well? No, that's sort of a mixed blessing. We would have much more vigorous competitors at these newly created investment banks, but I think that's good for America. I think when American investment banks are at the forefront of innovation. Now, not all innovation's good, but over time, the majority of innovation creates meaningful value for our economy.

Tell me, what's next for Citadel as a firm, beyond what you do now as a hedge fund manager on the investment side and a liquidity provider on the securities side? Two entirely different businesses, but both started by you and both with the Citadel name. I'm curious to know, what else might you do?

So right now the focus is on what we do and doing it better. If we look, here's a question. Who's the fifth-largest provider of downloaded music? I couldn't tell you. And you don't care. More and more in our economy, the market leaders really do enjoy very strong positions. And we want to be that market leader both in the hedge fund space and in the market-making space.

The Jack Welch sort of approach to being number one or number two, and if you're not one of those...

Then why are you there, right? The best people come to a firm that looks like that. Counterparties come to a firm that looks like that. We are able to make things happen from that position of strength.

So you're not thinking about or interested in expanding into any other businesses beyond the ones you're currently in?

Business lines very distinctly different from our current lines? No, we're not. And within those business lines that you're currently in?

Strengthen, strengthen, strengthen. Quantitative strategies have been remarkably successful for a couple of other hedge funds, more than a couple of course, but two that come to mind are Renaissance and Two Sigma. Will that become a bigger part of your business?

It's a big part of our business. It's been a big part of our business for a long time. Both of those firms are extraordinarily good at what they do, and the ability to continue to synthesize vast amounts of data and information to create predictive forecasts of securities prices is really important to our entire business.

You know, some people believe—and you've heard this surely many, many, many times—that artificial intelligence and machine learning are going to displace human beings in investing in asset management. What conclusions have you drawn about AI and machine learning?

So, I think that those observations principally come from those that don't use machine learning or AI. Those of us who are practitioners in the industry know that machine learning is really powerful when you've got a very large data set—very large data set—and where the patterns are consistent or persistent over time. When you end up in more bespoke situations—what's going to happen in France with the forthcoming election or the primary that just happened?—machine learning is worthless. You don't have any historical data to train the machine with. So machine learning is really good when you have a lot of history that you can train the computer with. It's not very good when you're dealing with bespoke or one-off situations.

So if you ask the computer, "How is Apple going to do in the next quarter?" it just doesn't have enough data to understand that question.

So how big a role do either of those approaches, pure AI or machine learning—how big a role do they have at Citadel?

They have a role. They're part of the toolkit that we use, but we use a broad toolkit to help support our portfolio managers in their investment decision-making.

Now, one of the other voids left by the banks has been in lending, and other hedge funds have filled that void by building private credit businesses. Is that something that interests you?

It's something we've obviously looked at over the years, and if I think about the next five to 10 years, perhaps. It doesn't make the one or two list for us. It's interesting for us. You know, what's great about the United States is that about 80% of the money that corporate America borrows comes from our capital markets. It doesn't come from our banking system. It's made our economy much more resilient, reduces the cost of capital. It fuels growth in American companies. Look at Europe: 80% of their money comes from a banking system that's struggling. Credit growth is anemic. The ability for banks to write off poorly performing loans is not there. It has a very negative impact on their entire economic landscape.

However, if you were to move in that direction, it would represent a departure from liquid markets, which is your specialty as of the moment. Yes. And sole focus, if I'm not mistaken.

Post-'08, the focus of Citadel has been liquid markets. We struggled in '08 like some of our competitors did and some of the banks did. We learned some very important lessons and for us, one of the key lessons learned was to stay focused in liquid markets.

And that's the way it's going to stay for the time being. That's where we are. Ken, as you know, Citadel has a reputation for being, I'm not sure what word to use, tough, ruthless perhaps, for chewing through people and spitting them out. You're the guy who runs the business. Tell me what it's like from your perspective.

So from my perspective, it's been 27 great years. I have worked with some of the brightest people in finance, period. And I've seen their careers blossom at Citadel, I've seen them make a huge impact on the world's capital markets. You know, we were the firm that, with J.P. Morgan, bailed out Amaranth, we bought Sowood's portfolio, we reshaped the U.S. options market. We're the first vibrant new competitor in the interest rate swap market. It takes a really special team to make that happen. It's in some sense like a professional sports team. And if you're no longer on your game, we don't have room for you on that team. But there's a lot of people that love to play at the absolute most upper echelons of the industry.

You've been recruiting talent for 27 years. Who fits in at Citadel and why?

What works? So what works are people who are passionate about finance. If you're just trying to get rich, it doesn't work. You've got to actually care about what you're doing because you live this job almost 24/7. You wake up and you have an insight. You go to sleep, you have an insight. In the middle of the night you wake up, you go, 'I didn't think about that yesterday and I should have.' So for people for whom this is a passion, they like solving problems, they like trying to figure out puzzles. Does it matter if they're old or young? It changes the way they view the world. My young colleagues, they love complicated, they love complexity. My older colleagues love simplicity. That's just us growing up.

So it does change, but I need a mix of both. I need the absolute, just insane creativity I get from some of my 24-year-olds, and I need the wisdom and experience of some of my 45- and 50-year-olds.

Ken, outside of Citadel, people know you as a philanthropist. They know you as somebody who cares about public policy. They also may know you as a Republican. When you consider the challenges that this country faces, what concerns you most?

Long run, I'm most concerned about education. The number of graduates that we create in the United States with a background in mathematics and science and engineering. I worry mostly about the amount of talent that we're putting on the playing field as we compete in a global economy. And one of the downsides of machine learning and artificial intelligence is we're going to reshape some very large parts of our economy over the next 10 years, and we need to be able to have both new companies formed on the basis of new ideas, new insights, and we're going to need to retrain a substantial number of people who are going to lose their jobs as this transformation continues to unfold. So I worry about both the robustness of our K-through-12 education,

I worry about our colleges that are not producing enough graduates with hard skills in the math and sciences, and I worry about our lack of commitment to post-college retraining of individuals who are going to have lost opportunities as we are able to automate certain parts of the economy away.

Do you have confidence that the federal government, not the only voice in education, but that this new government, A, recognizes the problem you identify and has a realistic plan to address it?

I think, unfortunately, there's nothing I've said that you haven't heard a thousand times before. This is not some incredible insight by some oracle from someplace. This is something that we've talked about for 40 years. And this is where we need the will of our political leaders to match the reality of what we need to do with our educational system. And we need to fight that fight pretty hard.