Just a short five years ago the concept of an algorithmic hedge fund led by quants was as bizarre a thought as was institutional investors allocating to “managed futures,” that oddly named odd-ball investment category that used derivatives to generated noncorrelated performance. All of these core investment concepts were sniffed at by the Wall Street establishment that acted as if the truly alternative space, those that delivered actual noncorrelated returns, were consecrated as unwashed heathen. Fast forward to June 2, 2016 and a Credit Suisse report titled “Quants in Vogue” and see just how quick the world changes.
Quants in Vogue: What happens when haute couture becomes mainstream?
Calling quants the investment world’s new haute couture, Credit Suisse’s Mark Conners said “the ‘House of Quant’ has firmly established itself as the Hedge Fund Industry’s most fashionable strategy due to its high quality product.”
Quants, their funds and the strategies that drive them have expanded over the years to various degrees, many becoming increasingly sophisticated. Described in a sentence, the “quant” alternative investment category is largely based on identifying patterns of behavior that have potential to be persistent. Initially popularized in the early 1980s based on momentum-based pricing patterns, the “quant” label expanded into other categories such as relative value price disparities, divergence and convergence back to a pricing mean, volatility and more recently into value-based investing strategies, among others.Sophisticated quant strategies are being built that attempt to replicate the portfolio manager’s thought process and create consistent and reasonably predictable performance.
“As Haute Couture, these funds create portfolios from an inventory of tailor-made fabrics or style factors, stitched together with highly calibrated tools,” Connors wrote. In fashion, haute couture clothing is designed by the leading fashion houses and practically targeted towards a narrow, elite audience. In quant investing, strategy over saturation, going from haute couture to Target, is a concern to a degree. Will the din of popularity dull the elite appeal?
Some strategies have practical limits to which they can grow. When assets under management become too large, niche market opportunities become less a realistic factor to move the needle on overall returns. Much like some in the hedge fund industry are currently suffering from overcrowding being a factor sometimes cited as causation for performance issues, the notion that algorithmic hedge funds can grow to infinity remains a question mark. What are the changes to performance when an elite Haute Couture fashion house moves into the mainstream?
What is the impact of market beta on the quants?
Perhaps one of the most interesting yet little discussed aspect of quants and their relative investing styles is the impact on market beta. While the mantra of hedge fund investing has been a search for “alpha,” many quant strategies rely on a beta market environment of price persistence to prosper, one of several examples. The most predictable of the strategies typically include a degree of market beta, the question that differentiates their performance is how efficiently and consistently that market beta is identified and extracted.
“Today’s premier Quant funds have moved beyond the Size, Quality, Momentum style factors popularized by Barra/MSCI, instead creating their own factors as new raw materials to drive their investment process,” Connors wrote. “So popular is the approach that several lines of lower fee, Private Label products have cropped up with monikers including Liquid Alternatives, Smart Beta and the like.”
Smart beta and liquid alternatives are attempts to package a basic algorithmic strategy into mainstream wrapper and offer daily liquidity. The goal, in part, appears to be to compete with hedge fund strategies but offer lower fees and tighter liquidity. When compared on a performance basis, however, such strategies have a mixed if limited track record.
Other hedge fund strategies are known to eye the quants and their entry and exit points for various clues to market behavior.
“Potentially taking a cue from Quant funds, macro funds are both covering and getting long crude and distillates-related futures – which may extend the rally,” Connors write, in part explaining the rise in oil pricing. “Short covering drove popular energy shorts higher, creating a vicious cycle of price increases and then short covering by ELS funds. Spotting the shift in momentum certainly translated to improved profitability by Quant funds and may account for the difference in risk appetite as measured by gross exposure.”
The impact algorithimic systems have on moving markets is undeniable. What will be interesting going forward is to see if the quants maintain their elite “haute couture” status as they become more popular?
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