Monday, October 20, 2008

How does the financial crisis affect quantitative trading?

Now that we are reasonably sure the financial world is not coming to an end yet, it is reasonable to ask how quantitative strategies have been faring under this extreme market stress. Despite reports of massive hedge fund deleveraging and negative YTD returns, I believe quantitative strategies, especially statistical arbitrage, have survived the period relatively unscathed. But here are a few of my thoughts:

1) The paltry 10% annual returns that a mediocre statarb fund can deliver is suddenly looking pretty good when the risk-free rate is under 1% and a prolonged bear market is on the horizon.

2) Mean-reversal models continue to beat momentum models in this crisis environment, as in previous crisis environments. This is not surprising because market returns have completely dominated specific returns, and of course market returns have been highly mean-reverting lately.

3) Models involving shorts are under some tumoil because of regime-change induced by new and ever-changing short-sale regulations. (For a while, I even have difficulties locating SPY for hedging purposes!)

4) Models are generally trained on data with far lower volatility than is recently realized. (Even incorporting VIX in a model does not guarantee that it can match realized volatility any better.)
As a result, P&L's fluctuations are also much higher than usual, which induces deleveraging as a risk-management measure, which drains liquidity from the market, which in turn leads to still higher volatility. The usual viscious cycle.

5) Political risks in an election year have further reduced leverage and increased volatility. What if there is an assassination? What if the wrong party got elected? What if the paper-trailess electronic voting machines cause another dispute for a month? The nightmares will continue at least until the morning of Nov 5.

6) Normally, lack of liquidity in the market is good for statarb models since they profit from renting out temporary liquidity. However, this profitability assumes that there are buyers of last resort for the market: the long-term investors, the mutual funds, Warren Buffet, etc. When they are absent, statarb investors can be left holding the bag. Fortunately, Warren Buffet & Co. has indeed stepped in and we statarb traders can breathe a sigh of relief.

7) I have been paying particular attention to 3 websites since the crisis began in order to judge whether I should return to my normal leverage: the Ted spread (I am waiting for it to return to below 2), the Calculated Risk blog, and Paul Krugman's blog. This crisis is caused by panic in the credit market, so we should look for credit market returning to normal before declaring victory. The VIX? Not so much because I believe it is backward-looking in this environment.

8) Watching Fannie, Freddie, Lehman, AIG, WaMu, Wachovia, Iceland, and the initial bailout bill failed feels like reading Chapter 8 of Harry Potter and the Deathly Hallows: "The Ministry has fallen. Scrimgeour is dead. They are coming." The Dark Lord is taking over our economy.

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