Thursday, April 16, 2009

The Quants' Role In Perpetuating Market Distortions

A relevant long-term proxy for the increasing presence and relevance of quant trading in equity markets is the widening volatility (width) in the advances-to-declines band (observed via ADLN in Bloomberg, or TICK for intraday breadth movements).



The latest widening of volatility bands for advance-decline occurred around start of quant craze. Long-short quants received large capital allocations from pension funds and endowments in 2004 and flood gates really opened up in 2005. By the end of 2005, relentless momentum chasing become the rule of the day and quants have taken over a large swath of trading landscape. There are many reasons for the explosion of this so called "portable alpha" concept that included market neutral quant funds, funds managing CDOs and other credit instruments. Cheap credit was, not surprisingly, the chief culprit. Quants feasted on cheap leverage and delivered steady returns, superior to treasuries with similar super low risk to AAA rated CDOs. Investors didn't know about the risks until August of 2007, but even subsequent, have learned nothing from this experience.

What this chart shows is that vast systematic volumes of quant strategies in various time frames have become a destabilizing factor due to a convergence of strategies. In the end, the only way to win is to buy stocks that go up and sell stocks that go down and all strategies, no matter how many PhDs portfolio managers are involved, and so quants had to be in the same stocks, at the same time, swinging the market widely under their own weight. The bigger funds took the lead and the goal of smaller ones become to figure out what bigger guys will do the next day.

The rest of the story of how the phenomenological price driven model took over the market action is history. Many books try to monetize by providing extensive explanations, some throwing around "philosophical" terms such as reflexology, other using assorted black birds to describe the simple phenomenon of the equilibrium point shifting after too many manic speculators jump from one side of the increasingly larger boat to the other. With the cheap credit spigot closed, not only are the same manic speculators now jumping off the boat completely, but the boat itself is becoming rapidly smaller. What/when the new equilibrium will be reached, is anyone's guess.

Quant funds followed the credit cycle and technology progress, and as computers became cheaper and credit/money got mispriced, quant funds developed into a dominant force. August 2007 was billed as a once in a 1000 years event that will never repeat. It did, though not as devastating, but painful nevertheless... And will repeat again quite soon.

Just what does the science of astronomy or physics have to do with uncertain, emotional markets? Why should the past repeat and why should large, highly leveraged positional bets be allowed on that premise? How is that any different from AAA CDOs constructed from sub-prime RMBS. Rating agencies made flawed assumptions, and now the prop risk managers allocating the bulk of the trading capital for the de jour hot quant manager, are making comparable mistakes, disguised as "assumptions" yet again.

CDOs managers bought RMBS aggressively, prolonging and exacerbating the housing bubble. Risk managers allocating capital to quants are prolonging and exacerbating the long-term bear markets in equities, creating an atmosphere of distrust and making markets unreliable tools of price discovery and playgrounds for rampant, Atlantic City-like speculation.

In the words of both a NYSE chairman, and a famous credit index trader, "this will all end in tears." Sphere: Related Content
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