Thursday, September 04, 2008

The Quants are dead...long live The Quants

As I have alluded to before on this blog, the proliferation of cheap computational power and access to algorithmic trading platforms has changed trading, money management, and indeed global financial markets. Quantitative traders ("Quants") are simply not immune from the quotidian business processes of competition, maturity, and commoditization.

We have obvious evidence of the trajectory of firms that base their trading skills on computers and the fantastically intelligent people who program them. This paper by Andy Lo gives a nice explanation of what happened and why during the credit crunch of last year and how it effected hedge funds.

Many Hedge Funds are simple. They employ computers to search for anamolies in the markets (such as the NAV of closed-ended funds vs. book value, credit spreads of similar debt products, identical equity securities in different jurisdictions, and debt convertible into equity). This type of trade used to be wonderful for sophisticated Quants. Large, expensive overhead was needed to run the models, but profits where simply there for the taking.

Like all businesses that make overplus profits, competition formed. Associates of these funds left to set up their own Quant shops, using very, very similar models.

Soon, thousands of funds were using the same algorithms which searched for the same anomalies. Opportunities appeared and then vanished in seconds instead of minutes. Margins on trades shrank. The competitive advantage for most funds was speed.

The Quant space grew larger. Institutional funds gazed the low-volatility, non-correlated positive returns of Quants and thought "panacea", then invested heavily to seek more market anomalies. With more entrants and huge increases in assets under management, time and profits were both being crushed by the gravity of capital.

And so to combat the thin returns, leverage was employed. A tiny anomaly levered 30 or 40-1 was not so tiny anymore. Competitors copied this practice. Once again, thousands of funds were using leverage to trade on the same anomalies, and devil take the hindmost.

But leverage works both ways. A 1% decline in an investment levered 40-1 is painful. A 10% move in such an investment may require a letter of apology to your investors for losing their capital.

So, once volatility increased across the whole panoply of financial instruments, many, many funds and strategies would be unraveled.

The Victors of this process are those Quants that can maintain and intellectual AND technological advantage. There are always anomalies and strange correlations in the markets. Those funds that can be creative in their use of algorithms, ask the market the most intelligent questions (based on a more scientific curiosity), and have the most sophisticated software will have the lion's share of success going forward.

So, in a certain sense, Quants as we knew them are dead. Long live the Quants.

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