The omniptence of artificial intelligence is unquestioned. The 'future' is automation, robotization, and algorithmic domination is the mantra of the new normal prognosticators – and anyone who challenges this world view is a luddite or 'denier'.
There's just one problem – those quantitative, AI-based, computerized algos, that are supposed to be making people obsolete in the financial markets, are in trouble. As Bloomberg reports, program-driven hedge funds are stumbling, a promising startup has closed, and once-reliable styles are showing weakening returns.
This isn’t just normal volatility confined to a single month, according to noted quant fund manager Neal Berger, the founder and chief investment officer of Eagle’s View Asset Management, a $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.
Bloomberg notes that June was the worst month on record for Berger’s fund, as usually robust strategies lost their footing and the firm fell 2.4 percent. 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.
There's "Turmoil in Quant Land", said Berger in a letter to clients this summer to explain his "candid view why strategies that were once working regularly mysteriously stopped working."
It comes down to two factors:
1.Increased competition: more investors are using algorithms to fight over the same inefficiencies in the market.
“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 $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.”
2. Low volatility: quantitative funds are most successful in an environment where there is large disagreements in the market over the prices of assets. Today there is little disagreement, and the best way to earn outsized returns is placed highly leveraged bets that the market will remain calm. That's working for some investors, but is far too risky for others.
In fact, the persistently low level of volatility has brought out an increasing number of hedge funds strategies oriented toward regularly selling volatility. Although we believe that this is "picking up nickels in front of a bulldozer", shockingly, these Funds have been some of the best performing strategies over the past years.
Although our guess is as good as anyone's, we believe the shockingly low levels of volatility has to do with an increase in computer driven, quantitative trading coupled with banks selling options to offer "yield enhancement" structured products to investors who are starving for this yield.
This feedback loop, the increase in assets run by hedge funds, and, the rise of quants, has created unusual patterns, dislocations, and low levels of volatility.
While those simply following the broader market indices wouldn't realize anything is amiss, it is our belief that these factors have created a challenging mix for trading oriented strategies. It won't last forever, but, it could last longer than we can.
Additionally, he explains, 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.
With all the geniuses in quant, high-powered computers, and enormous data, where are the "suckers" who are providing the juice for all of these absolute return quantitative strategies?
Simply put, the 'edge providers' have moved aggressively into passive index funds and broader market ETFs.
As such, we have a condition amongst the traditional quantitative strategies whereby we have robots trading against robots. Without a steady source of 'edge providers', these 'edge demanders' are just trading money back and forth with each other.
We believe increased quantitative trading coupled with passive indexation by retail, and, low levels of realized and implied volatility may be creating a feedback loop that has caused unusual price movements in a variety of securities that have challenged trading oriented strategies.
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.
…the shift toward passive indexation by those investors who have historically been the 'edge providers' has no end in sight. While one might argue that fundamentals always win out in the end (and we agree), we need to make money over a much shorter horizon for our investors and cannot sit idle in a world where hedge funds are expected to produce regular returns and stay ahead of the curve even if fundamentals are irrational. Over my nearly 30 year Wall St. career, I am a firm believer in the adage that "the markets can stay irrational longer than we can stay solvent".
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.
In order to exploit inefficiency, giant quant firms "need to be dwarfed by large, dumb money," Berger concluded by phone to Bloomberg.
"They’re waiting for the sucker to come to the table, but the suckers are fewer and far between."
Don't be the sucker, America.
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