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"There are good reasons for all investors to be adopting certain types of quant tools in their work. I think sadly a lot of people walked away from this with a more limited version of what quant firms do"
Max Darnell, First Quadrant |
The apparent free fall of the some of the world’s most respected quant shops in August has tarnished a whole section of the hedge fund industry. But is quant as an investment strategy to blame?
A recent theory put to the industry by MIT’s Andrew Lo and Amir Khandani is that the quantitative nature of the losing strategies’ significant losses experienced during the week of August 6 was purely incidental.
On August 7, 8 and 9, long/short equity market neutral strategies, or statistical arbitrage strategies, seemed to fall through the floor. Renaissance Technologies, AQR, BGI’s 32 Capital Fund, Black Mesa Capital and Highbridge, to name but a few large quant players, were all hit hard and reported to investors significant losses over the period. By the end of that week, most were down 7% on the month from those three days, some by as much as 18%.
The resulting kneejerk reaction by investors and the press was naturally that quants are inherently risky, and that the "black boxes" that many nay-sayers had been warning about were to be avoided at all costs. According to HFR, investors pulled $345 million out of equity hedge strategies in August. But Khandani and Lo claim that the losses are not indicative of the failings of quantitative strategies per se but rather of the systemic issues facing the entire hedge fund industry.
According to the aptly named report, What happened to the quants in August 2007?, Lo and Khandani hypothesize that the coincidence of losses at several quant funds was a result of such factors as too much leverage, and less liquidity than presumed, with the over-arching problem being too many managers caught up in similar or related trades.
The report puts forward several suggestions as to what triggered the losses that resulted in a sell-off and ensuing death spiral for quant funds – namely a large and rapid unwinding of one or more quantitative equity market-neutral portfolios, either because of the sudden liquidation of a multi-strategy fund or prop desk in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in the light of current market conditions or a change in business line.
That other equity market neutral funds then had to deleverage, or themselves unwind as a result, was not a quantitative issue, claim Lo and Khandani. The report suggests that over the past 10 years the number of long/short equity strategies has greatly increased. Furthermore, long/short funds, equity market neutral funds, and the burgeoning 130:30 products are all playing in each other’s territory. Statistical arbitrage funds are now pursuing lower-turnover sub-strategies to increase capacity, while long/short funds have turned to higher turnover sub-strategies as they develop more trading infrastructure and seek more consistent returns. There are quantitative elements to all the strategies, therefore, but the extent to which there was such similarity was not known in August. The report suggests that many of the quantitative portfolio construction techniques are based on the same historical data, such as value premium, size premium, earnings surprise, etc, and that there is a widespread use of standardized factor risk models that would explain why quant funds act in unison.
But Lo and Khandani go on to say that these techniques have been incorporated into non-quantitative equity investment processes and are used in fundamental bottom-up stock selection too. Therefore, if there is a sell-off by one very large quant fund, it is not only other quant funds that will be affected, and the more players affected, the greater the death spiral as funds rush to meet margin calls or beat a liquidity freeze. Losses for quant funds were further exacerbated by the increasing amount of leverage that had to be used to keep up with the higher returns of the past – again due to overcrowding and fewer opportunities. The authors suggest that 9x leverage would be required today for an equity market neutral fund to produce the same returns as a 2x levered fund in 1998. If managers had not been forced or scared into selling off on August 8 and 9, they might have been around for the big reversal on August 10 and only ended up down a few percent on the week.
All these events that combined to result in quant fund losses "are not particularly relevant to the efficacy of quantitative investing," say Lo and Khandani.
Max Darnell, CIO of First Quadrant, a quant manager for institutional and retail clients, agrees that the liquidity crunch of August does not mean quant funds do not work. "Virtually everybody who uses relative value as a discipline was affected, but more light shone on the quants because of the visibility of a couple of quant funds. A liquidity squeeze can affect any kind of investor.
"This summer was an opportunity for people instead to really look into quants and see that there are many different styles of quantitative investing, and that there are good reasons for all investors to be adopting certain types of quant tools in their work. I think sadly a lot of people walked away from this with a more limited version of what quant firms do."
Darnell, however, does agree that too many quant funds following a similar strategy played a major role in their losses this summer. "People were playing relative value strategies in the equity markets and they had worked well since 2001, but soon enough those cheap stocks are no longer going to be cheap. As more and more pile in with the belief that those stocks are cheap, the price will go up. Eventually, however, people will start to exit that strategy. Investors must not allow themselves to be only influenced by recent successes, and must seek to gauge how the opportunity of what they are buying may have changed. This is the same in every market, and for every type of investor. The lesson learned is that, if you find an investment strategy that works, others will find it too and then more capital will follow. Everyone needs to be looking at how it is they themselves and their competitors that are changing the opportunities and risks implied."