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Quant fund

Quant hedge fund? The steamroller of the credit crisis flattened nickel collectors in the equity markets that hadn't realized they were in its path. Damaged collateral caused collateral damage. Some quant funds saw their "hedges" become Texas hedges as shorts rose and longs fell. So-called "market neutral" strategies were short dispersion and got caught in a PREDICTABLE short squeeze. Market neutral is NOT risk neutral and there is no mean to revert to. Seek out crowded trades and take the other side. Dumb "logic": it hasn't happened so NEVER will happen!

The risk management rule I've always used is "If it can happen it will happen". Also "If it can't possibly happen, it probably will anyway". If the "smartest" economists and analysts say something is impossible then I know it is both inevitable and imminent. Manage your wealth on the assumption that global thermonuclear war begins tomorrow morning.

The trouble with standard deviation is it just measures STANDARD deviation. It's not rocket science. Rocket science is so easy compared to financial science which is why rocket scientists get into trouble trading. Nobel Prize "winners" have appauling track records because they just aren't intelligent enough. You need much more sophisticated systems and mathematical models than they are capable of understanding. The market is never "normal"; it oscillates from one extreme to the other. Very volatile or very steady. Chaos and complexity aren't black swans. They are omnipresent features of finance.

Sadly few others use it and we will see a pandemic of problems over the coming years due to failed financial dogma. VaR, cVaR, tVaR, ETL? All useless. Gaussian assumptions and gaussian cupolas! How can measuring dispersion from the mean be useful when central "tendency" itself is extremely unstable? Volatility is analogous to energy in that it can hide as potential energy but is ALWAYS lurking. Unless you have the resources, experience and expertise to make money from non-linear, non-rational financial phenomena yourself, wire your savings to the FEW managers that do. Today BEFORE the passive and beta repackaging crowd lose it for you...again.

"Low cost" index funds are very expensive. As are "hedge funds" that can't manage risk. which is 90% of the "absolute return" crowd. Curious how OFTEN these "once in a 100,000 years" storms occur and blow away anyone who hasn't battened down the hatches. Usually after just a long enough gap in time for amateurs to say volatility is "permanently" contained! The butterfly effect from US subprime mortgages has propogated to many other areas in finance. Those "securities" weren't very secure despite the "ratings". Credit ratings are even more biased than sell-side equity ratings. Ignore them and do your own analysis. Relying on someone who was paid to rate a bond "AAA" is as dangerous as a "strong buy" stock recommendation.

EVERY investment strategy is directional including the ones that market themselves as "non-directional". Interesting how some less robust and poorly stress tested models have major trouble when a NEW risk factor emerges. An investment edge means a manager WILL produce alpha in the long run but NOT necessarily every month. Some quant hedge funds have competitive advantages but most do not.

For those investors intent on redeeming from good quant hedge funds it is worth recalling that after the October 1987 crash, statistical arbitrage produced excellent returns in the following years. Statistical arbitrage has been around for a long time and has had several difficult periods like any other investment style. This overdue shake out will ultimately be a positive for good systematic hedge funds. No matter what happens I'd rather bet on alpha than beta. Before people get too hysterical about hedge funds they should remember the much larger amounts at risk in unhedged long only and soon heading for BIG losses.

"Quant fund" is as poorly defined as "hedge fund". Some quant funds have done well recently. There are not only factor models and stat arb within the quant space. Most of the better CTAs are quantitative. There is countertrend trading and volatility arbitrage among others. I am not a quant but I certainly utilise obscure mathematics and proprietary statistical measures to evaluate fund managers, develop investment models, price options PROPERLY and trading algorithms. Most viable investment strategies have an element of "quant" about them, even the so-called "discretionary" styles.

If you can't quantify your edge then you don't have one. Sorry but it is a fact. If you can't measure your risk you can't manage your risk. If you don't know whether the performance was alpha or beta then it was undoubtably from beta. You can test and evaluate quantitative trading methods rigorously but human discretionary funds rarely have a long enough track record to differentiate luck from skill. A bad period for some prominent, possibly oversized, quant hedge funds does not change the STRONG diversification case for quant strategies.

"Rare" events are NOT very rare and tend to cluster together leading to other "rare" events. Pundits seem surprised that what started in illiquid credit could affect funds as diverse as liquid equity funds, currency or energy traders. Contagion and hysteria will often impact leveraged strategies. The irrational swamps the rational yet again. Economic expectations and logical assumptions are not good for modeling such an inherently irrational and emotional process. Fundamentals are irrelevant when fear grips the markets and that in turn negatively effects the fundamentals.

The idea that "this has never happened before" is wrong. Volatility is not new. Correlation regime shifts are not new. Some "quants" use just 5 years of historical data so it is interesting that the storm hit exactly as the most volatile month this century dropped off their spreadsheets. DURING July 2002 the Dow fell 18% then rallied 12%. We've seen nothing like that, YET. Many quants have similar risk factor driven stock ranking systems so an unwinding means popular shorts go up while popular longs go down. Convergence trades only work if there are reasons they should converge. In a regime change "reasons" get overwhelmed by the shift from low volatility to high volatility. Historical relationships are just that - HISTORICAL. Beta and correlation just describe the PAST. We can learn from previous behavior but can't rely on it.

Factor models and statistical arbitrage are not black boxes anymore. More a crowded, transparent box. It used to be off the radar screen for most investors and involve relatively small amounts of money. But success has led to significant trade crowding and transparency of methods that MUST be kept proprietary. All arbs eventually get arbed out so you have to keep finding new ones. With every strategy there is a point beyond which the dangers of copycats exceed the rewards. However, just like credit hedge funds, there were losers AND winners in quantitative funds. High frequency trading is actually safer than low frequency trading and it was the "slower" systems that performed worst recently. Some smaller, more agile quant funds using different models and shorter time frames were able to arb the bigger funds.

To ANTICIPATE risks it is important to develop as much expertise and information sources as possible across products and geographies. There are other strategies and assets not YET impacted by the subprime meltdown. What started as a small part of the credit markets has spread to many other areas. Contagion is contagious and bear markets tend to RAISE correlations across risky assets. To anticipate risks you need to be aware of what is coming out of left field. Part of the problem is the silo mentality of a lot of the street; while cross-product expertise has grown the basic stance remains "I am equity, you are fixed-income, he is currencies and she is commodities" when in fact it requires competence across all asset and strategy classes. There is also a sharp divide between quals and quants when you need to know and understand both.

Deleveraging is having an effect on some good hedge funds just like in 1998 and the recent problems were probably inevitable. 1) Spreads have been getting tight requiring more leverage to maintain returns but the lending banks now want out necessitating liquidation of positions 2) Due to losses in OTHER areas investors are redeeming and quant funds are very liquid 3) Clients now demand more transparency and trade secrets have leaked allowing less competent funds to try to emulate the better ones. 4) Fund employees left to start their own firms but with the SAME strategy DNA eg Goldman Sachs Asset Management to AQR or DE Shaw to Tykhe 5) In some quant areas, capacity was surpassed a while ago but many funds continued to take in assets. It is not just the AUM in a fund, the total AUM in a strategy also matters.

If there is one term that needs to be removed from the fund marketing lexicon it would be "market neutral". Salespeople and other capital raisers love it since it sounds so "low" risk and sellable. But "market neutral" strategies just transform one set of risks into another set of risks. If you short 250 stocks in the the S&P 500 and buy the other 250, is that market neutral? Absolutely NOT. If you put on a Ford versus General Motors beta neutral pair trade. Is that market neutral? No. All you've done is transformed single security directional risk into double security directional spread risk and spreads can be even harder to forecast than the outright. You've introduced correlation issues that are even more difficult to model. You've also now got four trades to do instead of two. No strategy is MARKET neutral. More importantly NO strategy is RISK neutral.

Mean reversion assumes there actually is a stable mean to revert to. Some models are based on notions of economic equilibrium and no-arbitrage efficient markets, ie that prices "must" EVENTUALLY come back to someone's guess of fair value. Although there are many useful aspects of econophysics to trading just because there is a proven gravitational attraction between pairs of objects does not guarantee reliable FUTURE relationships between pairs of securities. Past market data is widely available and if you throw enough variables and optimizable parameters into a data mining model it is certain you will come up with patterns and factors that "predict" the past. What separates the good from the bad are those with the skill to find predictors for the future.

There is skill dispersion in quantitative hedge funds as in every investment strategy. Every fund has difficult periods and nothing has altered the fact that Renaissance Technologies remains the best quant firm currently operating. Their hedge fund product, Medallion Fund, is well up for the year and is where the managers keep their own money. In fact it doesn't need outside clients anymore. Medallion had a rough 1989 and any investors that redeemed THEN would have missed many years of subsequent high capital growth.

The 175/75 fund product in the news, the Renaissance Institutional Equities Fund, is NOT a hedge fund, has a longer term trading outlook and reveals more information. More disclosure attracts copycats which creates problems for everyone. Other firms have been trying to reverse engineer James Simons and his team's quant strategies since the excellent returns in the difficult year for many other firms of 1994. RIEF, being newer, larger, less opaque and nimble and 100% net LONG, has been closely watched by competitors since inception.

Contagion can affect any strategy. Bad funds can hurt good funds. DE Shaw had poor returns in 1998 mostly due to Long-Term blowing up but did fine afterwards. AQR shorted tech and internet stocks throughout 1999 and took a lot of pain before ultimately being proven correct in 2000. EVERYONE loses money sometimes. Say you are a good small cap stock picker and someone else is not good but also has a position in those stocks. That fund gets into trouble and investors and leverage providers want their money back. The bad fund is forced to dump the stocks you also own. Even though you yourself are good, you lose money. That is exactly what is going on in stat arb right now. Fortunately while the short term means problems for everyone in that particular strategy, in the long term the outcome is positive as the worst funds close down while the good funds will thrive.

I wish CEOs and CFOs would ask their CIOs and CROs about CDOs and CLOs before denying any exposure. Interesting how many insist on investing in things they "understand" and then proceed to pile into things they clearly never looked into other than the yield spread and "rating". The market decides what deserves to be considered AAA not some ratings agency. Almost by their own admission banks don't know what they don't know so they want their money back NOW from anything liquid. Contrary to popular belief the credit markets have not ground to a halt; cash credit may have temporarily but credit derivatives have seen massive trading recently. Could the next shoe to drop be in CDSs, SIVs or CLNs? CPDOs are priced a tad wider than "AAA" rated treasury bonds these days.

The 2/20 crowd are NOT to blame for quite rightly adjusting their portfolios. The 2/28 crowd, better known as mortgage brokers, were the catalyst. It is noteworthy how current laws won't let hedge funds sell to the mass affluent yet allowed subprime lenders to aggressively target less affluent homebuyers with predatory loans. They were clearly NOT making people aware of the risks with option ARMs and low 2 year/high 28 year loans which has put many in negative home equity and delinquency.

As usual it is all embedded optionality; the option to raise mortgage rates, the option to not pay those rates, the option to foreclose, the option to try to stay put and call a lawyer. Given the on-selling and repackaging of mortgages and structured investment vehicle conduits nowadays the ultimate owner is not always clear so the subprime mess is going to impact the markets for a long time. The credit default virus is already moving to higher grade credit areas.

I doubt the Dow will be above 10,000 by the time the credit crisis has been played out. Reverberations and panic are creating opportunities each day. At least good fund managers are taking action and reducing risk during this storm. I find this stay in for the long haul, ride out the turbulence "advice" ludicrous. Ships get to the nearest port and airplanes avoid hurricanes but index fund idols and sell-side strategists are mostly recommending staying invested in the stock market!

With some investment strategies having problems during this complex financial phase shift, getting hedged or getting out is surely prudent unless you are very confident of the skill and risk management capabilities of your fund managers or personal trading abilities. It is not as though "common sense" traditional stock and bond funds are immune. The long only crowd should dig their well before they are thirsty and DEFINITELY before everyone runs for the exits.

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