The Weakness of Quant Funds

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:

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.