Quants Dominate The Market; Unexpectedly They Are Also Badly Underperforming It

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Two days ago, JPM’s head quant made a striking observation: “Passive and Quantitative investors now account for ~60% of equity assets (vs. less than 30% a decade ago). We estimate that only ~10% of trading volumes originates from fundamental discretionary traders.” In short, markets are now “a quant’s world“, with carbon-based traders looking like a slow anachronism from a bygone era.

Bloomberg confirmed as much today, when looking at another divergence between quant funds and traditional, discretionary managers: “systematic strategies have barely budged from near-record participation in U.S. stocks. Meanwhile, fundamental equity long-short managers can’t afford to be anything but picky, considering the market’s narrow leadership. The result: the largest gap on record between humans’ and computers’ gross exposure to U.S. equities, data compiled by Credit Suisse Group AG show.”

As the chart below shows, and confirms what JPM already revealed, “for now, systematic traders are the dominating force in markets.”

What is just as curious,is that according to Credit Suisse “quants hit the highest gross exposure to equities on record around May 12. It’s since come down slightly, but still remains elevated.”

So in light of near record exposure, and a market that continues to grind higher to all time highs, one would expect the average quant to be having a banner year. One would be wrong, because as the WSJ’s Greg Zuckerman reports “this year is shaping up to be a dismal one for so-called quant funds, typically some of Wall Street’s hottest investors.” Some examples:

At Two Sigma Investments LLC, the $45 billion firm’s flagship Compass fund is down 2.5% this year through May 31, fund investors say. In 2016, the fund climbed 10.33% for the year and 15% in 2015.

 

AHL Dimension, a $5.2 billion fund that is the biggest managed by Man Group PLC’s Man AHL unit, is up just 2.2% this year, through June 9, after dropping 1.5% last year.

 

And Winton Group’s $10.5 billion Winton Futures Fund rose just 1.4% through June 7. It fell 3% last year and climbed less than 1% in 2015. The firm recently cut fees charged to its investors.

Overall, according to HFR, quant funds “which use sophisticated statistical models often developed by Ph.D.s rather than trade based on human research and intuition to find attractive trades” were up a modest 1.44% YTD drastically underperforming both the S&P’s 8.7% gain for the same period and the 5.7% return for the Vanguard Balanced Index Fund, which invests 60% in stocks and 40% in bonds, “highlighting how far quant hedge funds are lagging behind more traditional investments.”

You will see some very, very bad May numbers for a lot of firms,” said Andrew Fishman, president of Schonfeld Strategic Advisors LLC, which invests about $16 billion, including borrowed money, in various quantitative strategies. Which, in light of Bloomberg’s report, is paradoxical at best.

The returns, bad as they may be, have not stunted investor interest. As we have shown on numerous occasions, there has been a titanic shift in capital away from “expensive” active/discretionary strategies and into all forms of “cheaper” passive strats including quants.

Narrowing this down, HFR calculates that through the first quarter of this year, $4.6 billion of net new money was invested in quant funds, even as over $10 billion was withdrawn from non-quant funds. At the same time, more traditional investors are turning to sophisticated computer models to guide their trading, adding to the flow of money backing quant strategies.

Worst performing have been momentum funds, largely because many of the trends that worked over the past year, such as rising oil prices and a climb in the value of the U.S. dollar, have ended. Surprising strength for Treasurys and a lack of overall market volatility are among other reasons for the losses, investors say. It also explains the substantial, and often volatile, rotations that have been taking place below the otherwise calm surface of the market.

GSA Capital Partners LLP, a $7.8 billion firm that spun out of Deutsche Bank in 2005, saw its $3.8 billion Trend fund drop 7.6% through June 8, even as the fund received $1 billion of new cash this year, said a person familiar with the matter. The flagship fund run by Leda Braga’s Systematica Investments, the $5.5 billion BlueTrend Fund Ltd., is up less than 1% this year, through June 2. The fund, which takes riskier bets on market moves than many of its peers, fell nearly 11% last year.

 

And two funds run by Stockholm-based Lynx Asset Management, which manages $6 billion in its trend-following strategy, are down 7.4% and 4.8% through June 7, according to data sent to investors.

It is not uniformly bad performance: the occasional quant is outperforming, such as RenTec’s $14 billion Renaissance Institutional Equities LP fund, or RIEF, which is up over 10.5% this year, through May, while the $11 billion Renaissance Institutional Diversified Alpha Int. LP fund rose about 13.5% this year, according to HSBC data.

The firm has thousands of trading signals it relies on—from economic-data points to the value of global assets in real time—and employs computer science, statistics and more.

Trying to capture this performance, some funds are changing their methods to adjust to the new environment, “which some quants say has been especially challenging amid the market swings since the U.S. election in November.” As one would expect, in a market without clear direction, momentum funds are pivoting to other strategies, or at least trying to.

Florin Court Capital, a London hedge fund backed by Swedish investment firm Brummer & Partners, has largely stopped trying to make money from momentum trades in developed markets, a relatively simple strategy still used by many trend-following firms and other quants. Instead, it has shifted to more complex or esoteric trades, such as taking advantage of small differences in various maturities of a single bond.

 

Florin’s founder Doug Greenig, a former chief risk officer at Man Group’s AHL unit, says trend-following funds trading developed markets had been “languishing” and managers needed to look for new sources of returns.

Traditionally that is code word for leverage. Lots of leverage, like the 25x applied by the Asgard Fixed Income Fund profiled recently. It also confirms what Bloomberg reported earlier today: “as volatility in the stock market stays low, returns among quantitative strategies have been compressed, likely compelling managers to increase their leverage to juice up returns.

This “juiced up” leverage is why JPM’s Kolanovic calculated earlier in the week that just a modest increase in the VIX, from 10 to 15, could be sufficient to inflict “catastropic losses” for vol selling quants:

May 17th and similar events bring substantial risk for short volatility strategies. Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

Finally, one question remains: if virtually everyone, from quants, to hedge funds to vanilla funds are all underperforming the market, who is outperforming it?

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