The media seems to have an endless fascination with quant funds. Here is the latest article from the Economist magazine, summarizing the postmortem published by several researchers. (Hat tip, once again, to reader Mr. J. Rigg.)
The key points are as follows:
1) Quant funds are now becoming the primary market makers in many securities, which normally would provide liquidity and decrease volatility.
2) Unlike ordinary market makers, however, quant funds are highly leveraged.
3) Because of the high leverage, in the face of large losses these market-making quant funds are forced to liquidate their assets instead of buying them, thus behaving in a way opposite to ordinary market makers just when the need for liquidity is direst.
4) Thus quant funds are actually contributing to instability of the market despite their apparent market-making function.
Fortunately, when all else has gone wrong, there is alway Mr. Bernanke to count on ...
Sunday, October 07, 2007
Emerging market stocks have been reaching new highs almost everyday (see this article in the Economist magazine), and the natural resource sector has been on a tear as well. Given the giddy valuations of both sectors, which one is a better relative buy at this point? For those of you who have been following the IGE-EEM spread that I proposed before, its value is at an all-time-low these days -- it was at -6.77 standard deviations. Given their historical cointegration, I wouldn't be surprised if it will revert to a more sane value in the near future.
Saturday, October 06, 2007
Prof. Andrew Lo and Mr. Amir Khandani at MIT recently wrote a paper on "What Happened To The Quants In August 2007?" (Hat tip to my reader Mr. J. Rigg for the article). Most of their conclusions confirm what many observers already suspected: that the loss is likely due to the simultaneous forced liquidation of portfolios holding similar positions by various quantitative funds. What is noteworthy, however, is that they constructed a mean-reversion strategy and observed what happened to it during August. This strategy is very simple: buy the stocks with the worst previous 1-day returns, and short the ones with the best previous 1-day returns. Despite its utter simplicity, this strategy has had great performance since 1995, ignoring transaction costs. The Sharpe ratio was an astounding 53.87 in 1995, gradually decreasing to 4.47 in 2006. However, the strategy also had a disastrous few days on August 7-9, suffering a cumulative (arithmetic) return of -6.85% in those 3 days. Then on August 10, it rebounded, like the rest of the quant funds, with a return of 5.92%, almost reversing all of its previous losses. For me, this experiment reveals three interesting points: 1) a simple price factor seems to capture most of the performance of the complex factor models run by the gigantic hedge funds; 2) even technical mean-reverting factors suffer losses, not just momentum (growth) factors based on fundamentals; and 3) if one wants to avoid disasters and enjoy spectacular returns, even a one-day holding period is too long. I haven't done the experiment myself yet, but I bet that if we were to liquidate the portfolio at market close each day, not only would we avoid the loss of -6.85% in those 3 days, but would probably end up with a positive return of a similar magnitude!