The last five years have been mostly disappointing for quant investment managers, mediocre and inconsistent profits while stocks soar. But starting around six months ago, many quant strategies have delivered performance as good as any times in their histories. Is this a return to the good old days of consistent quant profits or a few lucky months to draw in return-chasing investors?
It’s important to understand that quant is not an asset class. Quant managers look for the same things qualitative managers do, and are exposed to the same market forces. Value managers, whether quant or qual, will do well when value is rewarded in the market, and badly during bubbles when the most overvalued stuff goes up the fastest. The same is true of quant macro, quant arb, quant momentum and other strategies.
The difference is the qualitative manager might pick dozens of undervalued stocks through careful fundamental analysis and some rough calculations to avoid overconcentration, while a quant manager might hold thousands of carefully calibrated value positions based on analysis of huge amounts of data with mechanical rules rather than careful human oversight. The quant manager hopes to make up with superior diversification and calibration anything lost up by omitting human judgement. Quant methods promise—and often deliver—the same profits as qualitative strategies with much more consistency and lower cost; that investors can use to build portfolios with superior risk-adjusted returns.
The chart shows the cumulative performance of the EurekaHedge Equity Market Neutral hedge fund index in blue. It delivered consistent good performance from 2000 through the end of 2016, 5.8% CAGR over treasury bills with 2.4% annual standard deviation, after which it seemed to stall.
But hedge funds are supposed to hedge. The real measure of hedge fund value is “alpha,” return adjusted for market exposure. An EMN fund, by definition, should run with zero correlation to the market. This allows investors to add it to index fund investments in order to boost returns without increasing risk.
Nevertheless, EMN funds as a group tend to run with positive market exposure, or “beta.” EMN funds had a 0.17 correlation to the market, not the zero promised in the name. The orange line on the chart subtracts off this beta exposure to show the pure alpha the funds delivered. While smaller than the unadjusted returns—4.0% per year rather than 5.8%—it was nonetheless generous compensation for the low level of risk, until it stalled at the end of 2015, a year earlier than unadjusted performance.
Why did unadjusted performance keep going up after alpha evaporated? Because the EMN funds took on far more market exposure, and market gains masked the negative alpha. After 2015 EMN correlation to stocks jumped from 0.17 to 0.61, as alpha fell from 4.0% to negative 0.7%.
The fund managers should not get all the blame. The EurekaHedge index weightings are based on investor choices. If investors pull money from uncorrelated quant funds and invest in high-beta funds—the ones with the best recent performances—the index beta will increase even if no manager changes parameters. While both quantitative and qualitative managers are known to exploit beta exposure, particularly in bad times for the strategy but good times for equity, as a group quant managers are more disciplined because they think in terms of beta and alpha, while qualitative managers often consider those Greeks to be two performance measures among many.
The phenomenon is not limited to EMN, although the statistical picture is clearest there. For nearly five years, alpha in some of the most popular investment theses has been scanty during the longest equity bull market in history. This tempted many non-quantitative managers to use market exposure to make up the difference, and many investors to do the same thing.
Today presents an opportunity and a danger. The opportunity is that alpha seems to have returned. Seven months is too short a period to be sure, but waiting until you’re sure can be costly. The danger is many of the funds with the best five-year returns have market exposure, not alpha.
These are uncertain times for investors. Assets in general seem overvalued, but holding cash is risky given the aggressiveness of fiscal and monetary policy. There’s slack in the economy which could power a tremendous bull market and soak up all that recently created extra money; or stumble on reopening pains and supply-chain issues, leading to crashes and stagflation. The 2020s might go down in history as another 1990s or another 1970s.
Diversification is a necessary ally in uncertain times (and a good one in all times). Quant alpha promises both diversification and good returns. Its returns have been weak since 2015, but the diversification remains, and returns might be back.
