Why Quantitative Funds are no Longer the Holy Grail for Investors and Trader in Residence

November 3, 2013

When quant funds came out, they were more or less rock stars on Wall Street. Since they first arrived on the scene in force in the mid-1990s, there have been great successes, as well as the occasional and spectacular failures. By and large, though, quantitative investing enjoyed a nice run until 2007. But from the second half of that year through well into 2009, quants underperformed both traditional managers and the market indices by significant margins. Since then, according to Morningstar, relative performance has stabilized, with quant funds gaining and edge over traditional hedge funds in 2010 and outperforming them soundly in 2011.

There are myriad hurdles for practitioners who pursue this style of investing. The headwinds facing quantitative investors were addressed in great detail in Challenges in Quantitative Equity Management, a Research Foundation of CFA Institute monograph published in 2008. Through surveys and interviews, authors Frank J. Fabozzi, CFA, Sergio M. Focardi, and Caroline Jonas sought to understand the factors that contributed to the recent period of poor performance as well as the ongoing challenges faced by quantitative managers

The authors identified three primary objectives motivating investment management firms to pursue a quantitative process: tighter risk control, more stable returns, and better overall performance. An earlier study by Casey, Quirk & Associates in 2005, titled “The Geeks Shall Inherit the Earth?” found that quantitative-driven processes did offer better risk-adjusted performance than did fundamental managers. Product diversification and scalability were also cited as reasons for implementing a quantitative process.

It is widely believed that the primary reason quant funds stumbled badly beginning in mid-2007 was correlation between managers, compounded by leverage. Common metrics of value and momentum, the argument goes, led quants to hold similar stocks. Then, when stocks began to sell off, many quant managers found themselves racing for the exits at the same time. Leverage employed by some players only compounded the problem. As the financial crisis unfolded in 2008 and 2009, the value bias of quant managers drew them to beaten-down financial stocks, Sadly, as the market rebounded in 2009, they were too slow to fully recover.

The improved performance of quants over the past two years may be attributable to the funds’ momentum-based models adjusting to the market’s upward trend as well as less competition on both the buy and sell side.

Challenges Ahead

Going forward, the authors argue, the significant challenges facing quantitative managers include correlating markets, style rotation, fundamental market shifts, and insufficient liquidity. They also point to “too many people using similar models and the same data” as a critical issue facing the industry. Underscoring this observation, the quant managers surveyed by the authors cited innovation, or the identification of new or unique model factors, as the most important strategy for improving performance.

The authors also discuss how the post-financial crisis investing landscape has been altered — and how quantitative investors must adapt to reshaping forces. In their view, uncertainty abounds: government interventions have distorted traditional value assessments in some fixed-income markets. Similarly, quantitative managers must assess the market impact of new and evolving regulatory reforms.

So does quantitative investing have a future? The answer likely hinges on the industry’s ability to adapt and innovate.

Trader in Residence – TiR

The DeGroote Trading Centers will be hosting Trader in Residence, a speaker series being industry professionals in DeGroote to discuss their success in their field of business. The series takes places every Tuesday at 5:30PM in the Ron Joyce Center, RJC, in room 136 and is also viewable via a 2 way camera in the Gould Trading Floor located at 122A in the DeGroote School of Business, DSB.

Drinks and food will be provided at the DSB location.

For further information regarding the series please visit: https://trading.degroote.mcmaster.ca/trader-in-residence/

The list of upcoming speakers is as follows:

November 5- Paul Allison-Chairman, Chief Executive Officer, and President -Raymond James Ltd.
November 12- To Be Announced
November 19- To Be Announced

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