Friday, 17 August 2007

The Quant meltdown or a tale of too much leverage?

As markets have declined, I've witnessed a surprising degree of schadenfreude from many commentators (including some of my friends) over the problems suffered by quant funds of late. Bloomberg has been rife with stories of problems at funds such as Goldman's Global Equity Opportunity, AQR and Renaissance.

Some have seized on these problems as 'proof' of the failure of quant investing. This is, of course, utter nonsense. No model works all the time, especially one based on valuation. For those familiar with Joel Greenblatt's Little Book that beats the market, he describes with glee the fact that the strategy fails in four years out of ten. Why? Because it means that those focused on the short term will be unable to follow the strategy in a disciplined fashion. This furthers the opportunity for willing to invest for the longer-term.

We all know that value strategies can have poor years (just recall the problems that value managers suffered in the bubble). Quant investing is just a method of removing the human from (much of) the decision making process. In the past I've written on the enormous evidence to suggest that quant models are superiour to human judgement in a wide range of fields (Chapter 22 of Behavioural Investing). The recent performance of quant funds does nothing to alter this.

However, this is not to excuse the quant funds. I've been surprised by the scale of the problem they have encountered. When I looked at the performance of a generic value strategy (such as price to book), the last few months have not been pretty. For instance, in the US a strategy of buying the cheapest stocks by P/B and selling the most expensive has generated a 3% negative return in July (and presumably worse in August - although I don't have the data to prove that).

Now a -3% return isn't that bad. It actually isn't anything out of ordinary for such a value strategy. The chart at the start of this entry shows the distribution of returns to the price to book strategy since 1926 (thanks to Ken French for the use of his data). In fact returns of -3% or more per month have been seen 10% of the time.

The mean return of the price to book strategy in the US is 0.4% p.m with a standard deviation of 3.5%. If we assume that the returns to value are normally distributed (obviously not a great assumption) then 95% of monthly returns should lie between 7.5% and -6.7%. So even a cursory glance at the data would reveal that July is nothing out of the ordinary.

How did the quant funds manage to translate this relatively normal occurrence into something so performance destroying?

I can think of three possible routes (not mutually exclusive) :

  1. They hadn't checked the long term data.
  2. They were using leverage.
  3. The trades were overcrowded
The first path is a major problem for many risk models that use short time periods to estimate their parameters (Chapter 36 of Behavioural Investing has more on this). It should be less of an issue in this context because we last saw a value meltdown in 2000 (i.e. relatively recently), so many managers will have already been aware of this.

The second route involves the use of leverage. Value strategies and leverage don't make easy bedfellows. Indeed John Maynard Keynes observed the dangers of combining a long-term view (which any value strategy must be - Chapter 31 of Behavioural Investing) with leverage. He opined "An investor who proposes to ignore near-term market fluctuations needs greater resources for safety and mist not operate on so large a scale, if at all, with borrowed money."

When I first heard that some of the quant funds were in trouble my first reaction was that they had been deploying leverage. This has recently been confirmed by a conference call between US analysts and the CFO of Goldman Sachs (taken from Street Events).

Susan Katzke, Credit Suisse:

Okay. And just I don't know if you covered this with Roger -- I might have missed it -- but in terms of the leverage in the funds, what are the leverage parameters, and where do you expect them to be going forward? Were they in retrospect a little bit higher than you would have liked them to have been or will be going forward?

David Viniar, Goldman Sachs CFO:

They were higher than we wished they were given how fast the market moved, but they were right in line with what had been expected. And the leverage at GEO as we sit here now is around 3.5 times, which is actually a little bit under where we had told people we would operate but probably around where we will operate going forward.

Susan Katzke, Credit Suisse:

Okay. And the 3.5 times just to clarify is with the $3 billion equity investment?

David Viniar, Goldman Sachs CFO:

With the equity investment.

Susan Katzke, Credit Suisse:

Okay. So closer to 6 times before that.

David Viniar, Goldman Sachs CFO:

That is correct.

So Goldman's Global Equity Opportunity fund was running with leverage of 6 times! This strikes me as madness for a value orientated strategy.

Overleveraged trades often go hand in hand with over-crowded trades. Cliff Asness at AQR wrote the following to his investors "This isn’t about models, this is about a strategy getting too crowded, as other successful strategies both quantitative and non-quantitative have gotten many times in the past, and then suffering when too many try to get out the same door. We knew this was a risk-factor but, like most others, in hindsight, we underestimated the magnitude and the speed with which danger could strike."

If there is something to be learnt from the problems the quant fund find themselves in, it is far less to do with the failure of quant and far more to do with the dangers of leverage.


Frank Ashe said...

James, glad to see you keeping your hand in.

What annoys me with so-called quant funds is the following. One of the justifications for quant, is that it supposed to keep the psychological biases to a minimum, but the biases are allowed to creep in via other mechanisms. When these psychological failings lead to the underperformance of the fund we get the quant mechanisms being blamed.

As you rightly point out, can the commentariat please target the correct failure.

Lest I appear as trying to be holier-than-though, let me say that as a Jeckyl and Hyde persona myself, I wish that my disclipline in some investing areas would be applied to my speculative dabblings (especially in down markets), but then they wouldn't be as exciting.

Spencer said...

Shouldn't you be watering the roses or something?

Although Quant funds help reduce the bf biases in stock selection, they retain the behavioural tensions arising from our industry's demand for regular predicable outperformance. The Quant funds in trouble retain a very short term investment horizon. Leverage shouldn't be a problem per se provided the underlying clients were aware of its implications for the volatility of returns.

Mr B said...

Hi James

Successful investing is about caring what happens but not minding about the short term outcomes. Quants don't care, so the market takes it's revenge. Plus like every parasite, once you overcome the host, you end up eating each other.

Steven said...

Isn't it amazing how the financial press only talks about the role of leverage on the downside? When these same funds generate positive returns, 100% of it is attributed to the genius of the fund manager!

Steve said...

The main problem I think is that (naive?) investors or plan sponsors expected that quant would provide a steady, incremental return. But that is only possible with cash (in your home currency). To generate returns from atrategies that actually only showed a little, if any alpha, they had to employ leverage. As someone wrote, that is great on the upside but we know what happens on the downside. The previous heroes are not suddenly idiots but the shortcomings of their approach were not apparent or ignored (see The Halo Effect book). Hopefully, the recent episode will remind everybody that you can't make equity returns from cash type volatilty and you can't turn BBB or worse into AAA just by paying rating agencies.

Anonymous said...

If the current failure of Quant funds was to be attributed to overleveraging, then their positive performance should be judged accordingly.

But at the end of the day, isn't the decision to leverage one's strategy a "human" one ?
So they maybe not be completely rid of human emotion after all..

kindest regards
Alex Spiroglou

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