The Weakness of Quant Funds

In the wake of the MIT Techonology Review’s twopart

story on the summer quant-fund blow-up, there’s a fascinating and high-level

debate going on in the blogosphere about whether this marks the End of the Quant

Era. Veryan Allen says

it doesn’t, and has some good one-liners, to boot:

Quick investment tip: never, ever risk money on anything with the word "Gaussian"

in it. Gaussian things make the mathematics easy which is why they don’t work…

Few investment managers admit to using that big institutional no-no called

technical analysis despite the fact that many do. But calling it quantitative

analysis is still ok, just.

Meanwhile, the great mathematician and philosopher Baruch Spinoza (or at least

a fund manager in Switzerland writing under his name) makes an

impassioned plea in favor of humans over machines. There’s actually less

difference between the two than it might seem at first glance: they differ only

in their opinion of whether it’s really possible to be a quant fund which doesn’t

behave like all the other quant funds.

But Spinoza does make one important point: that if a market-neutral strategy

blows up and the fund has to be chaotically unwound, then the effect on the

market as a whole is neutral, and in fact the absence of quants might have greater

systemic consequences than their presence did.

For every long that was sold there was an offsetting short that was bought.

Directionally, which is what I believe Bookstaber and Buttonwood refer to

when they discuss systemic risks, there was no impact from the Quant meltdown.

If I am right, by the way, when I say that one impact the quants did have

in stocks was in dampening overall levels of volatility (selling stocks that

rise and buying those which fall) from 2003 to 2007, then nervous nellies

like Bookstaber and Buttonwood will in fact miss them when they have faded

back into the obscurity that beckons; Quants’ absence will increase

volatility and the magnitude of directional movements in markets and stocks.

The Epicurean Dealmaker then wades

in to the debate with a few points backing up Mr Spinoza, but he concentrates

on what he calls "the apparent epistemological and ontological underpinnings

of the Grand Quant Paradigm".

Maybe it’s just me being persnickety, but I think that both TED and Spinoza

("The Quants and Herbert Blank are toast for now. Their sin is epistemological")

are getting their terminology in a little bit of a twist. What they’re trying

to say is that the physics-based underpinnings of quant technology are based

on objective, real-world fact (ontology). But that the quants make

a kind of category error when they try to apply those same technologies to something

dynamic and ever-changing like markets: a rule which was true of gravity, say,

ten years ago, will also be true today, but the same can’t be said of a rule

which was true of the markets ten years ago.

The error, then, is in the quants’ ontology, not their epistemology: it’s in

what they consider to be facts, not in what they (think they) know. Or, alternatively,

the error is in their belief system: it’s that they believe that the

markets behave in predictable ways. In other words, their sin is not epistemological,

it’s doxastic.

That said, quant-fund managers are well aware that their strategies don’t last

forever, or even, nowadays, for much longer than a few months at best. They

don’t kid themselves that there are any universal truths about markets which

can be easily arbitraged and monetized. But they do think that at any

given point in time there are some temporary truths about markets which

will give them their precious alpha. If you want to invest in a quant fund,

then, make sure you can answer two basic questions in the affirmative:

  1. Will markets always offer these temporary arbitrage opportunities?
  2. Is my fund manager capapble of identifying these opportunities, not only

    now but in the future as well?

Even then, however, there’s the problem that these opportunities are getting

ever smaller, both in size and in duration – which means that in order

to generate superior returns, your fund manager will have to use increasing

amounts of leverage – or, if he doesn’t, he will have to have the discipline

necessary to accept smaller returns just for the sake of keeping his leverage

down. Is that something you think both of you will be happy with? And how do

you think a standard 2-and-20 fee structure in any way provides an incentive

to keep leverage to a minimum?

I’m with Spinoza on this one, at least insofar as he’s calling an end to the

quant boom. I’m not convinced that his brand of fundamental analysis is much

better: there’s precious little empirical evidence that fundamentals-based investing

is any more successful than any other strategy. But it’s certainly easier to

explain and to justify.

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