Fung & Hsieh: Someone definitely yelled “Fire!” in the theater. The question is: what movie were they watching?

Pensions & Investments reports this week that quant managers all scrambled for the same exit doors last week because they were all in the same theater at once.  Lehman’s Matthew Rothman tells the newspaper:

“The traditional quant factors that everyone (uses) because they work — like EBITDA (earnings before interest expense, taxes, depreciation and amortization) to EV (enterprise value), price momentum — did very badly. The more correlated you were to these factors and to other managers who use them, the worse you performed.

Jim Simons’ letter to investors concerning the recent performance of the quant behemoth Renaissance Technologies echoes the same idea.  Simons says:

August (down 8.7% through today) is a different story. The culprit is not the Basic System but our predictive overlay. While we believe we have an excellent set of predictive signals, some of these are undoubtedly shared by a number of long/short hedge funds. For one reason or another many of these funds have not been doing well, and certain factors have caused them to liquidate positions.

Citigroup’s research department has also been tracking this phenomenon.  Citi’s Manolis Liodakis (see previous postings) says:

“A dramatic increase in correlations among what were perceived to be orthogonal factors is the big challenge for quant portfolios. Average 20-day pair-wise correlation among value, quality, momentum and revisions moved up to 56% on Wednesday [August 8]. The long-term average is less than 10%.”

Haven’t we seen this movie before?  “…factors that everyone uses“, “…shared by a number of funds“, “…increase in correlations“?  This all sounds strikingly similar to another of today’s hedge fund industry megatrends – hedge fund replication.  After all, the goal of factor-based hedge fund replication is also to identify factors that seem “to work” and trade them in a calculated, albeit passive manner.  So are quant funds becoming a sort of proto-factor-replication strategy?  And if they aren’t, should factor replication strategies even attempt to emulate quant funds?

We put these questions to noted hedge fund researchers professors David Hsieh of Duke University and William Fung of the London Business School.  As regular readers will know, Profs. Fung & Hsieh have been at the forefront of hedge fund research and analysis for many years and now conduct a significant amount of research into factor-based hedge fund replication.

In an email to earlier today, Hsieh hypothesized that someone in quant-land yelled “Fire!” in a crowded theatre [Ed: the media?] and started the rush for the exits.  He also revealed an interest in studying this amorphous and ill-defined, but obviously significant sub-strategy of the hedge fund universe.  Said Hsieh:

“If enough funds trade the same strategy, then the following must be true:

  1. their returns are correlated [pointed out in our Review of Financial Studies 1997 paper]
  2. the common strategy has a simple trading rule, which we call a “primitive trading strategy” [pointed out in our Review of Financial Studies 2001 paper.]
  3. Common strategies that can be replicated are given in our Atlanta Fed Economic Review article in 2006 (see related posting). These include: trend following, long/short equities, merger arbitrage, convertible arbitrage, etc.
  4. When a few funds trade a strategy, and it makes money, we call it alpha.  When many funds use the same strategy, they create a beta or factor. Replication is the attempt to capture this common strategy in a low cost way. It may or may not be doable. We have not studied ‘quant’ strategies, but when we do, we may well find a primitive trading strategy that captures the common strategy in these funds.
  5. We know that, in a crowded theater, it is not possible for everyone to exit at the same time. This gives rise to a classic ‘bank run’ problem. We may have seen one in ‘quant” strategies.'”

In a telephone conversation with Alpha Male this afternoon, Fung agreed with his long-time colleague, saying these funds were definitely exploiting some form of quant “alternative beta” at the moment someone yelled “Fire!”.  In any case, said Fung, existing factor replication models aren’t adequately capturing the dynamics of the hedge fund industry as a whole, let alone a sub-strategy such as quant funds.  Ergo, proving exactly what these alternative betas were will take some work.

So for now, anecdotal evidence is all we have to explain the sudden stampede for the exits.  Time (and more research from Fung & Hsieh) will hopefully reveal what movie these managers were watching when the fire alarm was pulled and panic broke out.

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