By Dani Burger
For computerized strategies that are supposed to be making people obsolete, quants are looking decidedly human in 2017.
Program-driven hedge funds are stumbling, a promising startup has closed, and once-reliable styles are showing weakening returns. A handful of investment factors, the wiring of smart-beta funds, have gone dormant.
This isn’t just normal volatility confined to a single month, according to Neal Berger, the founder and chief investment officer of Eagle’s View Asset Management, a US$500 million fund-of-funds that invests with 30 managers, half of them quants. Returns have been decaying for a year, suggesting the rest of the market has figured out what the robots are doing and started taking evasive action, Berger said.
June was the worst month on record for Berger’s fund, as usually robust strategies lost their footing and the firm fell 2.4 per cent. The worst pain has been among quants in the market-neutral equity space, which take long and short positions to isolate bets on price patterns and relationships.
In order to exploit inefficiency, giant firms like Two Sigma Investments LP and Worldquant LLC “need to be dwarfed by large, dumb money,” Berger said by phone. “They’re waiting for the sucker to come to the table, but the suckers are fewer and far between.”
Berger made waves in professional circles last month when he trumpeted the death of certain quantitative tactics in a widely circulated letter. His thesis: Systematic strategies require an endless supply of victims to thrive, and the growth of quant and passive funds has caused dumb money to behave unpredictably or disappear altogether.
Considering the industry’s growth and all the press it’s gotten this year, the bout of futility comes at a bad time.
“The vast majority are not having a good year,” Fred Branovan, president and chief operating officer at family office FFC Capital Corp, said by phone. “Market neutral funds need volatility to do well, and the daily increases in the equity markets make it very hard to short in this environment.”
While measuring the space is difficult considering the warring definitions and the way managers slice up money among different brokers, Barclays Plc estimates quants manage US$500 billion, accounting for 17 per cent of total hedge fund assets. But then there’s also fundamental investors who have incorporated some systematic styles into their processes. Not to mention the watered down quant of smart beta exchange-traded funds, a US$625 billion industry in the U.S. alone.
Whether Berger’s thesis is correct, the damage is real. Consider R&F Capital Advisors LP, a once-promising venture started by a former Two Sigma engineer and a Paloma Partners Management Company executive. The quantitative hedge fund is winding down after deciding to shutter the firm earlier this year, according to a person with direct knowledge of the matter who asked to remain anonymous.
Bucking The Trend
There are also travails Clinton Group Inc., a quantitative hedge fund that manages more than US$2.9 billion and hadn’t posted a down year since launching in 2006. The New York-based fund ended slightly down last year and has slumped about 5.5 per cent in 2017, according to a person familiar who asked not to be identified.
Representatives from R&F Capital did not respond to phone calls seeking comment. A spokesman for Clinton Group declined to comment.
To be sure, there are quants that bucked the trend. The US$3.5 billion Quantitative Investment Management saw its tactical hedge fund return 37.2 per cent in the first seven months of the year, while Renaissance Technologies’s equity-focused fund gained more than 9 per cent, according to investor documents seen by Bloomberg News.
All this, even as the equity market has gone straight up, with the S&P 500 Index gaining 11 per cent to a record.
According to Berger, the world is moving to a situation where “pedestrian” quant strategies like trend-following or factor investing won’t survive. Underpinned by decades of academic study, factors like value and momentum aim to take advantage of behavioral economics theories that say investors overlook cheap securities, or tend to bid up stocks that have gained in the past.
A growing number fundamental managers incorporate factors in their investing process: 43 per cent of respondents at Bloomberg LP.’s Buyside Week event said they use the strategies for risk management or portfolio construction. Factors also underpin smart beta ETF assets, which have more than doubled in the past four years. This popularity may doom them to weaker returns.
“Now every bank has a factor model,” said Benjamin Dunn, president of the portfolio consulting practice at Alpha Theory LLC, which works with managers overseeing about US$200 billion. “You’ve had a democratization of a lot of data and analytics that were once the domain of very systematic quant investors. Everything is getting arbitraged away.”
A market neutral version of value is on track to post its worst year since at least 2008, according to data compiled by Bloomberg PORT. And factors aren’t just performing poorly, some are barely performing at all. With equity markets bathed in tranquility, groups of stocks assembled according to their growth, momentum and volatility traits have never been more muted, the data show.
Simple strategies like pairs trading may have also been quieted by index funds. For example, a classic bet is one that assumes Coke and Pepsi will behave similarly. If Coke rises while Pepsi falls, a program automatically shorts Coke and buys Pepsi. To work, there must be investors willing to buy Coke, even if it looks overvalued compared to Pepsi. But if most people purchase S&P 500 Index funds, they’re buying and selling both at the same time.
At Eagle’s View, Berger says the situation will take skill to navigate. He’s holding on to managers that have proven to be sophisticated and uncorrelated, and is looking into opportunities to take advantage of the massive flows into passive. Otherwise, he’s cut strategies that require high levels of volatility to succeed.
Eagle’s View is shifting “almost entirely away from mainstream quant strategies due to the fact that we feel that they are too crowed and without enough juice available for all to feast,” Berger wrote.