1
Introduction
In the financial markets, the competition gets tougher every day. Today, the difference
between 25th and 75th percentile performance of money managers in some sectors of
the industry is measured in basis points. The only trading and money management firms
that survive now are the ones that continually discover cutting-edge position selection
strategies and technologies to build better quality trading and investment systems. Where
once traders and money managers based decisions on greed and hope, now rational self-
interest controls discovery processes that promote fact-based decisions and implement
proven research.
Entrepreneurs refer to the discovery process as knowledge-based innovation. In
finance it has begotten a new discipline: systematic trading and investment, the reasoned
study of financial markets using the scientific method to explain and replicate market phe-
nomena and the use of computer automation to make profitable trading/investment deci-
sions. Today, entrepreneurial activity in financial markets revolves around the practice of
systematic innovation^1 to build new (and shut down old) trading and investment systems.CHAPTER ◆ 1
A top-rated hedge fund company stopped accepting new money in 2004 and started liquidating posi-
tions. In 2005 management shut down the fund completely. Their diligent and continuous research made
it clear that their models were no longer working. There was a fundamental shift in their ability to arbi-
trage convertible bonds and they told their investors to take their money back. Every investor is waiting
anxiously for them to open their next fund. (Compare that to Long Term Capital Management.) Ideally,
the hedge fund manager should have been building new strategies ahead of time so that they could have
kept the customers ’ money by switching funds.The key determinant of sustainable competitive advantage is the ability to continu-
ally discover, build, and operate better trading/investment systems. Which is to say, in
financial markets the new business model is quality: higher returns, lower risk, and lower
cost, all at a faster time-to-market. This model is complicated, though, by the tendency of
many skillful fund managers, traders, and financial engineers to fall short when it comes
to process engineering.^2 Other industries have faced this same problem.
In manufacturing plants, small margins demand reductions in waste and costs of
reworking defective parts. High quality is necessary to gain and maintain market share.