Which is an absolute must for quants

The criticism of quant funds is becoming fundamental

The first six months did not go well for quant funds, so criticism was to be expected. One allegation is particularly dangerous, however.

It's not going well for quant funds this summer. Only 17% of the large active quant funds beat the US Russell 1000 index in June. In the first six months of the year, the losses averaged more than 4%. Two years ago they were considered the ultimate on Wall Street, but those days are over. The criticism has become unmistakably loud.

Quant funds, a sub-category of hedge funds, base their investment decisions on quantitative analyzes using mathematical models. Often there are many excellently trained physicists or mathematicians in their cadre. However, according to one of the main allegations, social and economic processes cannot be reliably converted into mathematical or statistical models. In addition, because all quant funds have similar models, they are prone to overcrowded trades; in these, many players hold large and similar positions, which makes entry more expensive and brings with it the risk of insufficient market liquidity when exiting.

Therefore, some critics complain that quant funds are not delivering the performance they promise. They are expensive, but regularly lag behind their benchmark index. Quants themselves have often defended themselves in recent years by pointing out that this comparison is unfair. Firstly, it is nonsense to compare a hedge fund that is not 100% invested in stocks with a pure stock index. Second, a benchmark comparison during a record long bull market cannot capture the strengths of the approach. These only became apparent in difficult times on the stock exchange.

Quant funds as a lifeline

That is plausible, because in contrast to the more strictly regulated conventional funds, quant funds can also bet against individual values ​​and sell stocks short. This theoretically makes them independent of market developments. In 2008, investing in hedge funds paid off. It is true that the promises of “absolute returns”, profits in every stock market situation, were not fulfilled during the financial crisis; but while the S&P dipped nearly 40%, the hedge funds lost less than 20%.

Many investors think of this episode in today's market environment, and the longer the bull market lasts, the higher amounts flow towards hedge funds and quant funds. They are supposed to offer protection against a general slump in the stock markets. Investors accept any underperformance as an insurance premium.

The stock market times are no longer as quiet as they were at the beginning of the year. Impending trade disputes, the Fed's interest rate hikes and the simmering euro crisis have played their part in the fact that volatility on the markets increased sharply in February and March and is only slowly falling again. It is precisely in these circumstances that the quant funds should prove themselves. And they don't. The most dangerous accusation, which basically calls into question the right to exist of quant funds: They are incapable of fulfilling their task as a security vehicle.

The competence of fund managers

AQR's equity market neutral fund was hit particularly hard. The company manages almost $ 230 billion and is one of the most prominent players in the market. Nevertheless, the fund fell 4.8% in June, the worst monthly result since it was launched four years ago. This brings the fund to a negative return of 8.7% this year, while the Russell 1000 index has only lost 5.8% over the same period. The Renaissance Institutional Equities Fund was at least just slightly positive in the first half of the year; however, it lost around 3% on the S&P 500, even though it was designed to beat it.

If investors in a market-neutral fund like AQR's Equity Market Neutral have to accept a minus of almost 9% in 6 months, it makes sense to question the competence of the fund manager responsible. But it is not easy to tell whether a fund manager is incompetent. Maybe it is pure luck that ensures an excess return, possibly pure bad luck that leads to a negative performance. Looking at it with the help of simple statistics leads to worrying findings.

Some active fund managers base their selection of stocks on their benchmark index. For example, suppose a manager does not track the index exactly, resulting in a 15% variance. What are his chances of outperforming the index over 10 years? Even if he loses an average of 3 percentage points a year on the index, his chance is almost a third (29%) of beating the index.

Great influence of luck and bad luck

Random results also affect competent managers. The annual standard deviation of the Swiss stock market is 19%, the real return is 6%. What are the chances that a manager will perform worse than Swiss stocks over a period of 10 years, even though he achieves an additional return of 2 percentage points in the long term? The worrying answer is 27%.

Investors must therefore state that even long-term benchmark comparisons are hardly able to reliably differentiate between capable and incapable active managers. The huge impact of luck and bad luck is probably one of the reasons why fund manager compensation has a relatively low correlation with performance. For the quant funds as a group, the high probability of random outcomes also brings some consolation; it is quite possible that the poor performance of many quant funds in the first half of the year is pure bad luck.

Despite the weak phase, investor money continues to flow into quant funds and other hedge funds. Critics attribute this to the habit, lack of information and skillful marketing of the hedge funds. However, it is also possible that the investors are well-informed and assume that their expertise will overcome any bad luck over a long period of time. It would be better to say: over very, very long periods of time.