Wednesday 12 October 2011

While waiting for normal service to be resumed..please read this!

Please read this
"Beneath the cacophony of screaming headlines about the European debt crisis,
Occupy Wall Street and the slumping U.S. economy lays the struggles
that quantitative hedge funds have recently endured.
Hedge funds just went through their worst quarter since the 2008 crash,
and an industry source told me that quant-based funds were hit particularly
hard during the period by wild swings throughout the global markets.
The world's hedge funds lost 5.02 percent of their assets during the third-quarter,
according to Bank of America's Hedge Fund Monitor, their worst performance
since a 9.48 percent decline for Q3 of 2008. So far this year,
hedge funds have fallen by 7.8 percent through the end of the third-quarter,
according to the Dow Jones Credit Suisse Hedge Fund Index
"
Alex Spriroglou
I have always been suspicious of equity markets and many who work in them becuase only a fool could not have made money in the very strongly defined trends we have seen in them over the last 20 yrs. So it's all the more ridiculous when the bleating and whining starts during the sharp corrections/bear phases.
The real test is the ability to make money out of a falling or sideways market often where no defined trend is apparent. A skill that many of these huge funds seem unable to perform regardless of their quantative approach.

below (written after the crash in 2008 by another author)....

"Quant shops aren’t sitting around idly. They are pressing into new realms of computational finance, applying concepts from molecular physics, mathematical linguistics, artificial intelligence and other scientific disciplines. Thales, for example, is using computer simulations to replicate human behavior to try to predict the myriad decisions that drive trading activity. Other firms are pinning their hopes on machine learning — statistical methods that allow computers to identify relationships in financial data and make predictions from them. But regardless of the approach, managers agree that quant funds have been far too focused on equities and need to find ways to apply their strategies to a broader range of asset classes"..

Well, maybe they obviously have not learnt anything form history

and also written in 2008 by someone else

Quantitative trading? The steamroller of the credit crisis flattened nickel collectors in the equity markets that hadn't realized they were in its path. Damaged collateral caused collateral damage. Some quant funds saw their "hedges" become Texas hedges as shorts rose and longs fell. So-called "market neutral" strategies were short only dispersion and got caught in a PREDICTABLE short squeeze. Market neutral is NOT risk neutral and there is no mean to revert to. Monitor for crowded trades and take the other side. Dumb VaR "logic": it hasn't happened so it NEVER will happen!

It's not rocket science. Rocket science is easy compared to financial science which is why rocket scientists often get into trouble trading. Nobel Prize "winners" have an even worse record. Need more sophisticated systems and mathematical models than they are capable of understanding. The risk management rule I use is "If it can happen then it will happen". Sadly I know of few others that use it. The trouble with standard deviation is it just measures STANDARD deviation and is therefore no use. The market is never "normal"; it oscillates from one extreme to the other. Very volatile or very steady. Chaos and complexity aren't black swans as they are omnipresent features of the markets.

VaR, cVaR, tVaR, ETL? All useless. How can measuring dispersion from the mean be useful when the mean itself is extremely unstable? Volatility is analogous to energy in that it can hide as potential energy but it is ALWAYS lurking. Unless you have the resources and expertise to model and make money from non-linear, non-rational financial phenomena yourself, wire your money over to the FEW fund managers that do. Before the long only and beta repackaging crowd lose it for you...again. "Low cost" index funds are very expensive. As are "hedge funds" that can't manage risk properly.

Curious how OFTEN these "once in a 100,000 years" storms occur and blow away anyone who hasn't battened down the hatches. Usually after just a long enough gap in time for amateurs to say volatility is "permanently" contained! The butterfly effect from US subprime mortgages has propogated to many other areas in finance. Those "securities" weren't very secure despite the "ratings". Credit ratings are even more biased than sell-side equity ratings. Ignore them and do your own analysis. Relying on someone who was paid to rate a bond "AAA" is as dangerous as a "strong buy" stock recommendation.

EVERY investment strategy is directional including the ones that market themselves as "non-directional". Interesting how some less robust and poorly stress tested models have major trouble when a NEW risk factor emerges. An investment edge means a manager WILL produce alpha in the long run but NOT necessarily every month. Some quant hedge funds have competitive advantages but most do not.

For those investors intent on redeeming from good quant hedge funds it is worth recalling that after the October 1987 crash, statistical arbitrage produced excellent returns in the following years. Statistical arbitrage has been around for a long time and has had several difficult periods like any other investment style. This overdue shake out will ultimately be a positive for good systematic hedge funds. No matter what happens I'd rather bet on alpha than beta. Before people get too hysterical about hedge funds they should remember the much larger amounts at risk in unhedged long only and soon heading for BIG losses.

"Quant fund" is as poorly defined as "hedge fund". Some quant funds have done well recently. There are not only factor models and stat arb within the quant space. Most of the better CTAs are quantitative. There is countertrend trading and volatility arbitrage among others. I am not a quant but I certainly utilise obscure mathematics and proprietary statistical measures to evaluate fund managers, develop investment models, price options PROPERLY and trading algorithms. Most viable investment strategies have an element of "quant" about them, even the so-called "discretionary" styles.

If you can't quantify your edge then you don't have one. Sorry but it is a fact. If you can't measure your risk you can't manage your risk. If you don't know whether the performance was alpha or beta then it was undoubtably from beta. You can test and evaluate quantitative trading methods rigorously but human discretionary funds rarely have a long enough track record to differentiate luck from skill. A bad period for some prominent, possibly oversized, quant hedge funds does not change the STRONG diversification case for quant strategies.

"Rare" events are NOT very rare and tend to cluster together leading to other "rare" events. Pundits seem surprised that what started in illiquid credit could affect funds as diverse as liquid equity funds, currency or energy traders. Contagion and hysteria will often impact leveraged strategies. The irrational swamps the rational yet again. Economic expectations and logical assumptions are not good for modeling such an inherently irrational and emotional process. Fundamentals are irrelevant when fear grips the markets and that in turn negatively effects the fundamentals.

The idea that "this has never happened before" is wrong. Volatility is not new. Correlation regime shifts are not new. Some "quants" use just 5 years of historical data so it is interesting that the storm hit exactly as the most volatile month this century dropped off their spreadsheets. DURING July 2002 the Dow fell 18% then rallied 12%. We've seen nothing like that, YET. Many quants have similar risk factor driven stock ranking systems so an unwinding means popular shorts go up while popular longs go down. Convergence trades only work if there are reasons they should converge. In a regime change "reasons" get overwhelmed by the shift from low volatility to high volatility. Historical relationships are just that - HISTORICAL. Beta and correlation just describe the PAST. We can learn from previous behavior but can't rely on it.

Factor models and statistical arbitrage are not black boxes anymore. More a crowded, transparent box. It used to be off the radar screen for most investors and involve relatively small amounts of money. But success has led to significant trade crowding and transparency of methods that MUST be kept proprietary. All arbs eventually get arbed out so you have to keep finding new ones. With every strategy there is a point beyond which the dangers of copycats exceed the rewards. However, just like credit hedge funds, there were losers AND winners in quantitative funds. High frequency trading is actually safer than low frequency trading and it was the "slower" systems that performed worst recently. Some smaller, more agile quant funds using different models and shorter time frames were able to arb the bigger funds.

To ANTICIPATE risks it is important to develop as much expertise and information sources as possible across products and geographies. There are other strategies and assets not YET impacted by the subprime meltdown. What started as a small part of the credit markets has spread to many other areas. Contagion is contagious and bear markets tend to RAISE correlations across risky assets. To anticipate risks you need to be aware of what is coming out of left field. Part of the problem is the silo mentality of a lot of the street; while cross-product expertise has grown the basic stance remains "I am equity, you are fixed-income, he is currencies and she is commodities" when in fact it requires competence across all asset and strategy classes. There is also a sharp divide between quals and quants when you need to know and understand both.

No comments:

Post a Comment