There is a distinct echo of CP Snow’s famous 1959 Rede Lecture, The Two Cultures, in the modern financial world. There are quants and non-quants. Back in the 1980s, a quant was an exotic and rarely spotted creature toiling away in the financial backwaters. Now they are centre stage. When it comes to bragging rights – over remuneration, seniority or profile – the quants can crow loudly. Firms across the financial world are falling over themselves to hire those with quant skills to measure and manage risk, and structure and trade ever more complex products.
In money management, the modern quants leave such mundane matters as indexation to computers and traders. They are storming the barricades of hedge funds and grabbing their share of the glittering prizes. In the spirit of disclosure that seems to be a regulatory requirement these days, your columnist should declare that he is a non-quant, or, at best, a member of the ultra-lightweight wing of the delinquent tendency. However, some of my best friends in finance are quants and many more have distinct quant leanings.
The following statement is, therefore, completely dispassionate. Quantitative money managers will find it increasingly difficult to thrive. The losses suffered by some of the biggest names in quant in August mark a watershed. Strategies that have been sold as inherently more scalable than other hedge funds have been shown to be no such thing. Alpha is a zero-sum game, whether you get a hunch and buy a bunch or deploy serried ranks of maths PhDs and teraflops of computing power.
To be clear, the quant funds affected by market volatility this year are in fact a relatively small part of the quantitative universe. They are hedge funds of two sorts: global macro funds that can be thought of as long/short versions of global tactical asset allocation; and long/short equity market neutral funds. The founders of these funds often cut their teeth at long-only firms but pushed for the ability to short because finance theory shows that long/short portfolios are more efficient if a manager has skill.
Theory is fine. But in markets if lots of people are doing similar things, the chances are that they end up scrapping over ever-diminishing alpha. When Goldman Sachs Asset Management launched Global Alpha in 1997 it was at the esoteric fringe of investment management. But its success has spawned many imitators. Now firms running quant funds make up half of the top 10 hedge funds groups by assets under management ranked in Alpha magazine.
They would no doubt protest that they are pursuing very different strategies and tapping diversified sources of alpha. The behaviour of markets in August and November suggests that this is questionable. Quants train at the same handful of elite graduate schools, where they share the same tutors and read the same books. They attend the same conferences to hear the same presentations and subscribe to the same academic and practitioner journals.
They are even members of the same clubs, Q and IAFE, rather than White’s or the Garrick. The prominence of quants in modern finance is not just a story of "the revenge of the nerds" as unofficial dean of quants Andrew Lo likes to quip. The uncharitable might also call it "the rise of the clones".
It is not surprising, therefore, that the half-life of many quant strategies has been dramatically shrinking. Once upon a time it was relatively easy to make money from market anomalies such as the January effect and earnings surprises. No more. So, in the effort to uncover profitable arbitrage opportunities, no stone is left undisturbed. The effect, magnified by leverage, is that correlations now exist between the most neglected byways of markets, especially in times of distress.
Even if the quant funds can brush up their investment processes and continually unearth new quirks in the data, they now face a pressing business issue. Most quant funds are sold as low-risk, predictable-return, market-neutral products. For good or ill, many investors, encouraged by quants, choose to assess hedge funds according to a reward-to-variability measure such as the Sharpe ratio (return minus the risk-free rate over the standard deviation of return).
For any fund that stumbled in August or November, those Sharpe ratios will no longer look so sharp. CTAs have often struggled to attract institutional money in spite of excellent returns because of poor Sharpe ratios. No doubt they will be revelling in Schadenfreude. The very quants that insisted that risk-adjusted returns are what matters have been hoist by their own petard.
The default response of money managers with a difficult product to sell is to start new funds with clean track records. That is already happening. However, if these funds simply offer more of the same they will fail. There has, in effect, been a quant arms race in recent years. Ever more resources have been thrown at the data to extract the latest wrinkle. To prosper in the future, new approaches will be needed, perhaps incorporating aspects of behavioural finance, for example. The quants might even need to hire from over the cultural divide.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own