In the wake of the MIT Techonology Review’s two–part
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:
- Will markets always offer these temporary arbitrage opportunities?
- 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.