"Quant Fund Pain" Story on CNBC

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If you would like to see the video, Click here to watch. This morning, another CNBC commentator blamed part of the market’s problems on some Quant funds that have gone south which has led to people liquidating their shares. I’d argue it is quite the opposite - the market is going south which is resulting in Quant fund underperformance. Due to the irrational nature of the market, Quant funds should be expected to perform poorly. This was a theme that I started to watch in August of last year. If you would like to take a look at my post from August ’06, simply click here. My take on Quant Fund performance (or lack there of it) is merely another indicator that we are in the initial stages of a bear market. Two things take place at market tops that handicap Quant strategies.

1. Market Breadth deteriorates meaning the majority of stocks decline while a few large names hold up the cap-weighted indexes.
2. Investors are irrational during inflection points.

Quant Investing 101 Quantitative Investing (Quant) is the most rational (or the least emotional) form of active management. It involves using various computer algorithms that are entirely objective and completely eliminate the human element from investing while trying to find unrealized value in the market. Quant funds are to Wall Street what Card Counters are to Blackjack tables in Vegas. They seek to take advantage of small inefficiencies in the market and do it over and over and over again. Because there are so many inefficiencies in the market, successful Quant managers, such as Bridgeway Funds and GMO Funds, can deliver above average returns on a fairly consistent basis. One important attribute of Quant funds is that they have a lot of holdings. No one position makes up a large part of their portfolio. This theme is integral to my argument. Before I continue, I’d like to state that I have long been a strong believer in Quant investing and have used numerous Quant based money managers in my portfolio. Currently, I have eliminated all Quant Funds in my portfolio for the reasons I’m about to outline. Market Breadth Deterioration Because Quant Funds hold a lot of positions, they tend to underperform when market breadth deteriorates. When Market Breadth deteriorates a large numbers of stocks underperform the market while a few large-cap names outperform. Because the indexes are cap-weighted, weaknesses in the market is hidden for quite some time. Market breadth peaked in Mar/Apr and has been declining ever since. It’s deterioration has accelerated the last couple of weeks. For confirmation of this idea, simply chart the Russell 2000 versus the Dow for the last several months. From this comparison it is clearly evident that only a few of the larger names are holding the market up. Investors are Irrational Market inflection points (tops and bottoms) are characterized by extreme irrationality on the part of investors. Quant strategies are purely rational; therefore, it stands to reason that in an irrational market, rational strategies won’t work. Back to our Blackjack example. Think of a card counter in Vegas who is sitting at the end of the table and the dealer is only using one deck of cards however everyone who is playing in front of our card counter is being completely irrational. Hitting on 17. Hitting when the dealer’s up-card is a 6. This is what the Quant analyst is dealing with. His advantage has been taken from him as he is helpless in an irrational market. Conclusion I’m afraid there may be some dark days ahead for Quant Funds, which is a shame as they are some of the most intelligent and ethical people in the business (especially the good folks at Bridgeway Funds.) In my Market Outlook, I explain why the next 12-24 months is going to be like no market we’ve seen in the last 30+ years. The one knock on Quant strategies is that they are slow to adjust when their models quit working. Over time, markets figure where they are inefficient and close down arbitrage opportunities that Quant funds prey on. For example, one of the most popular hedge fund strategies in the late 90’s and early 2000’s was Convert Arbitrage but its success ultimately lead to its demise as too many investors where attracted to the space and it got squeezed. Most Quant models were created when the market was experiencing low inflation and bond prices were appreciating. We are about to see a secular shift in these two trends which I outline in my Market Outlook. This secular shift is going to have a profound impact on equities and may very well make many of the Quant models that are being used today obsolete.