Read This Before Investing In That Quant Fund

June 1, 2017

Read This Before Investing In That Quant Fund

  • As long as there is stability, quants will do well. But when liquidity goes, so goes the quant fund.
  • Long Term Capital Management is a perfect example of how quickly a quant trend can turn into a quant fad.

Introduction

Quants are the hot thing on Wall Street.

Common sense doesn’t seem to work anymore as stocks are completely detached from their fundamentals and capital flows don’t really react to macroeconomic or specific company news. In an environment where no one knows what to do to beat the market, it’s completely normal for new trends—or better, new fads—to rise to a level of fame that will turn to notoriety.

The latest new fad, alongside the ongoing ETF and passive investment craziness, are quant hedge funds. As the investing environment is rigged by the huge liquidity provided by central banks where the European Central Bank is even buying corporate bonds, hard core investors who want to beat the market have to look for something new. Passive investments are good if you want to do as the market does, but if you want to beat the market, you need something different. The different is usually provided by value and all-weather investments in the long term, but such investment vehicles aren’t sexy enough for the greedy investor. In such an environment, quant funds have found their place under the sun and are growing fast.

Does This Remind You Of Something?

It reminds me of the 1990s and 2007, when quants were also growing fast. However, they were localized to the U.S. Now, the quant phenomenon is global.

Globalized quants will bring trouble when the party ends. As long as everything grows, the economy, money supply, and employment, all is well. The moment things start to turn, especially if liquidity dissolves, the majority of quants won’t be prepared for such an environment as there will be no liquidity for their programs to execute their strategies. When such funds get in trouble, investors will demand their money back. Most funds won’t have the necessary liquidity and will simply default.

As a perfect example and a warning, let’s discuss the story of Long Term Capital Management (LTCM). LTCM was founded by the former head of the Solomon Brothers’ trading desk, John W. Meriwether, and two Nobel prize winners, Myron S. Scholes and Robert C. Merton. You might be familiar with them from the option pricing Black-Scholes formula.

LTCM’s strategy was pretty simple, just take advantage of the mis-pricing among liquid securities around the globe. On August 17, 1998, Russia defaulted amidst the Asian crisis. This was a surprise because it was thought that a country couldn’t default on its domestic debt as it could simply print the necessary money. Surprise, surprise, Russia removed another big chunk of liquidity from the markets and LTCM was toasted. LTCM’s returns were stellar in the first few years when everything was linear and there was plenty of liquidity. When that changed, the fund defaulted in a few months.


Figure 1: LTCM’s returns went from great to a total loss in just a few months. Source: University of California at Irvine.

The modern quants are the same as LTCM was, just more sophisticated and can tell a convincing story to the investor.

I was just reading an article on Bloomberg on how up to 2007, quants could only take into account a few factors. However since then, quants are able to really dig into big data and even analyze earnings calls. For example, by using an artificial intelligence technique, Goldman Sachs (NYSE: GS) has stated that it can look for verbal cues in an earnings call that will indicate whether the analyst will be bullish or bearish on the company. Such a strategy might seem very sophisticated and smart, but it’s based on the presumption that the analyzed analyst can move the market with their opinion. There are analysts that can really move markets, but they can only do it for a while and only as long as the market behaves in a linear way. As we know, analysts are completely wrong when the economic environment turns. Consequently, the program used by the quant fund will also be wrong.

Should You Invest In Quant Funds?

Even the biggest passive managers like Blackrock and Vanguard have their own quant funds. This goes to show just how far the trend has gone.

Let me tell you a simple truth that is essential for any kind of investment success you can have. In the end, it all boils down to how tasty the sardines are.

Let me explain, sardines once disappeared from their traditional waters in Monterrey, California. When there is limited supply of a good, its price usually goes up which is exactly what happened to sardines. It also happens that traders jump into the market and further inflate prices. One day, a sardine trader decided to eat this luxurious and expensive meal he was trading. Unfortunately, he soon became ill and told the seller that the sardines weren’t good to eat. The seller replied that those weren’t eating sardines, those were trading sardines.

Before you invest in anything, whether it be quant funds or something else, be sure whatever is behind such a financial instrument is eatable in the sense that it has some real value. If you invest in a quant that takes advantage of price differences in high yield bonds through an algorithm, even if the fund does extremely well for a while, nothing is going to save it from the imminent collapse in value of high yield (junk) bonds.

History, especially in financial markets, continuously rhymes. This is because very few remember the songs of the past. Be sure to learn as much as you can about what happened in the past to limit your downside and increase your upside in the future.