Fancy math can’t mask the fact that quantitative investing strategies essentially rely on pattern recognition: Models look to correlate past periods of superior returns with specific factors including value, size, volatility, yield, quality and momentum.
Once the latter are identified, fund managers construct portfolios with specified return and risk parameters consisting of securities that match those optimal characteristics.
Other techniques exploit short-term dislocations between individual prices and comparable securities or the broader market, betting that the relationship will eventually revert to normal.
Such approaches have several fundamental weaknesses. First of all, quant investing is tainted by hindsight bias – the belief that understanding the past allows the future to be predicted.
Given enough time, money and computing power, a strategy predicting high returns can be found and validated using back testing to check its historical performance. But, this heightens the risk of overfitting, or adjusting the model to suit a specific set of historical conditions.
Those may look like a winning recipe, but could turn out to be an historical fluke.
Modelling is also affected by practical matters, such as what data is or isn’t available. London Business School researchers found over 300 factors that could be used to develop potential strategies, heightening the risk of an overfitted model. There is in addition the problem of ergodicity, that is, the lack of a truly representative data sample.
It’s important to remember, too, that financial eras are characterised by specific policies, market structures, instruments and investors. Unique conditions that shape returns, volatility and correlation may change.
While models create an illusion of sophisticated certainty, they can’t capture the full range of events that produced a particular outcome and could perform poorly where a paradigm shift occurs. Modern markets may simply be too complex to be modelled accurately.
Quant strategies naturally lack transparency, given that asset managers are reluctant to disclose too many details and lose their competitive edge. This, however, increases the risk of gaming.
A low-volatility fund, for instance, might buy illiquid assets whose prices change infrequently, thus giving the illusion of stability. Some strategies, such as selling options, might produce a lot of small gains but be vulnerable to large losses if market conditions change.
Increases in funds under management may create competition that reduces a strategy’s expected return. Where the size of funds increases, the strategy could become crowded, making trading difficult and creating unpredictable profits and losses.
At their most basic level, quant funds are selling hope with a financially catchy name.
Investors disillusioned with below-expected returns are switching to low-cost index products.
To counter this trend, fund managers have sought to seduce investors with complex and opaque black-box strategies, made credible by the rocket science on which they’re supposedly based.
Fund managers can then collect their high fees (the standard 2 per cent on assets under management plus an additional 20 per cent of outperformance) on the promise of future performance.
While there will always be some standouts, it’s not clear why so many managers can claim sustained superior performance. The basic technology, data and expertise is readily available.
Logically, the anomalies that the strategies rely on should dissipate. There is an inherent contradiction in that the approach exploits inefficiencies, but requires market efficiency to realign prices to generate returns.
The reality is that any fund managers possessing a magic investment formula guaranteeing low risk and high returns would have no incentive to share the secret.
Successful firms such as Renaissance Technologies have closed some funds to outside investors, preferring to capture the returns for themselves.
As legendary investor Paul Tudor Jones once noted, if there was a single easy formula to follow, then all investors would already be rich.
Bloomberg
from A Viral Update http://bit.ly/2QXy8Lv
0 Comments