In an Alpha magazine article published today, Clifford Asness (founder of AQR Capital) and colleague Adam Berger launch a spirited defense of quant funds – saying they are not “black boxes” or reincarnations of the HAL 9000 from the movie 2001: A Space Odyssey. The article is full of other colorful analogies that have become Asness’ trademark and it’s well worth the read (here – available without a login right now).
In “We’re Not Dead Yet” Asness writes:
“It’s not hard to see why people might think quant strategies are dead. Recent performance, fears of overcrowding and the current market environment could easily lead one to question the viability of these strategies…we don’t think these concerns hold water.”
Asness and Berger base much of their argument on the belief that investors are irrational and that there are “fundamental, deep-seated, flaws in the way most investors make decisions.” These result in trading opportunities (such as momentum and value a la Fama & French) which are likely to endure well into the future – regardless of the short term health of the hedge fund industry.
As the duo puts it:
“…someone who says quant investing has no future is basically saying that value and momentum will no longer work to pick investments.”
But they also acknowledge that poor performance over the past year might make you think otherwise, and that the steady track record of value and momentum over the past 60 years may not continue in the future. While unable to make any promises, they point out that “…it has worked over a very long period and nothing looks strange now.”
So if quant investing is all about extensions to the tried and true Fama/French factors, then what happened in August 2007? Naturally, any defence of quant investing needs to address the highly correlated and negative returns of that month.
According to Asness and Berger, quant managers often target constant volatility not constant dollar exposure. As a result, they lever up in times of low market volatility and lever down in times of higher volatility. The problem last August, they say, was that many quant managers were using higher leverage than usual at that point in the cycle. As a result, a pure Fama/French model with no leverage would have actually performed much better that month than most quants.
If the basis of quant investing is so obvious and well-known by many investors, then how can the strategy possibly continue to generate excess returns? Even though most investors are aware of these market anomalies, Asness and Berger point to the stubbornly high spread between fundamentally “cheap” and fundamentally “expensive” stocks as evidence that markets remain inefficient.
But what about the recent bans on shorting and the curtailment of leverage? Surely these factors impact the ability of quant managers to implement their strategies. Again, Asness and Berger argue that the common perception is wrong. They point out that many quant funds are long-only and that market neutral versions tend to reduce their demand for shorts and leverage during times of high volatility anyway. So the very volatility that has stifled shorting and curtailed leverage has simultaneously decreased the need for these tools.
Ironically, Asness and Berger conclude that merely being asking if “quant is dead” is actually an encouraging sign for the strategy. They invoke the famous 1979 Business Week cover story “The Death of Equities” as evidence that…
“…reports of the death of many investing strategies have often been highly profitable investment opportunities because they suggest that the strategies are close to hitting bottom.”