high-teching the herd
[so now we need a quant fund that will identify the stocks that other
quants are investing in to time short sales of those stocks after
they run up!]
Wall Street Journal - August 24, 2007
How the ‘Quant’ Playbook Failed Federal Filings Confirm the Finger Pointing: Funds Often Shared Stocks — Leading to Losses By JUSTIN LAHART
The managers of “quantitative” hedge funds that got roiled in this
summer’s stock-market selloff didn’t gather after work to drink beer
and swap trading ideas. But they might as well have.
A number of quant funds, which use statistical models to find winning
trading strategies, reported heavy losses this month. In many cases,
the managers pointed their fingers at other quantitative hedge funds,
essentially saying they all owned many of the same stocks and their
models told them all to sell at the same time, driving down the share
prices, hurting everyone in the process.
In a letter to investors, Jim Simons of the hedge fund Renaissance
Technologies wrote the quantitative funds behind the selling
“undoubtedly share some signals in common with our own, and the
result has been losses.” It didn’t help that quant funds are among
the fastest expanding categories of hedge funds.
Filings with the Securities and Exchange Commission show that as of
the end of June, quantitative hedge funds often shared large
positions in the same stocks. Renaissance held 1.1% of the shares
outstanding of NVR Inc., a Virginia construction and home-building
company. AQR Capital Management, another quant fund, held 0.9% of the
company’s shares and quant fund Numeric Investors had a 1.6% stake.
NVR stock, which closed yesterday at $571 a share, trades less than
most companies of its size. The shares have bounced higher since the
selloff, but they are off 8.4% over the past month.
The overlap in quant funds’ positions wasn’t limited to NVR. Satya
Pradhuman, director of research at Cirrus Research, which analyzes
small and midsize stocks, found 148 other companies with market
capitalizations between $2 billion and $10 billion where large quant
funds owned 5% or more of the shares outstanding.
As a whole, those companies’ shares underperformed the shares of
other midcap stocks during the selloff. Mr. Pradhuman found 473 small-
cap stocks, with market capitalizations of $250 million to $2
billion, where the quant funds owned 5% or more of the shares
outstanding. These stocks also performed worse than other similar
stocks.
The midcap companies where quant funds held big stakes included
packaging company Pactiv Corp., toy maker Hasbro Inc. and managed
care provider WellCare Health Plans Inc. Small caps included printer
Deluxe Corp., consumer-products company Russ Berrie & Co. and health-
care equipment maker Zoll Medical Corp.
Academics, notably Eugene Fama at the University of Chicago with
Kenneth French at Dartmouth, have documented how, over time, stocks
with smaller market capitalizations and lower valuations tend to do
better than the overall stock market.
The reason for the outperformance, Mr. Pradhuman said, is both
smaller companies and companies with low valuations are more likely
to go bust if the economy sours, so they are riskier. Since the U.S.
economy has been highly successful, taking the risk of buying the
shares of such companies has paid off.
Since history had shown that buying small and low multiple companies
was a good idea, many quant models screened for them. When stocks
started getting rattled last month after credit markets seized up,
worries about business risk rose sharply and the shares of those
companies bore the brunt of the selling.
Other investors had bid up the share prices of some of these
companies in the belief that leveraged-buyout firms would snap them
up at healthy premiums. When credit tightened, takeover prospects
dimmed. The combined effect of some quant funds and other investors
cutting positions in the stocks sent them lower still.
Mr. Pradhuman said quantitative investing still makes sense, and
indeed many of quant funds that got hurt in the selloff have already
made back the money they lost. “Quant strategies may be getting broad-
brushed,” he said. “In the long term, these are disciplined
approaches that are doing things at every tick to look for value.”
The risks to quantitative investing may be rising. Even if they don’t
share the same statistical models, quant funds share similar
approaches to the market. They are schooled in the same statistical
methods, pore over the same academic papers and use the same
historical data. As a result, they can easily come to similar
conclusions about how best to invest.
What doesn’t exist in the data that the quant funds comb through,
however, are the quant funds themselves. Scientists talk about the
“observer effect,” where the very act of observing a phenomenon, such
as the behavior of animals, can change the phenomenon. For the quant
funds, this effect is magnified, because they aren’t merely observing
the market, but using what they learned to take part in it. That
effect was amplified by the rapid growth of these funds. AQR, one of
the most successful quant fund managers, has about $35 billion under
management, up from less than $7 billion nine years ago, though not
all of the money is in these specific strategies.
University of Rochester finance professor William Schwert has found
that after academic papers come out highlighting opportunities to
outperform the market, those opportunities tend to diminish or
outright disappear. The popularity of quantitative strategies in
recent years may mean that the opportunities to make money are
getting whittled away more quickly than ever, according to Invesco
PLC investment strategist Diane Garnick.
“You have this inflow of dollars into quantitative strategy and this
inflow of intellect,” she said. “It’s becoming more difficult to
capture outperformance.”
To stay ahead of the game, quant managers need to be more aware of
what their peers are doing, said Massachusetts Institute of
Technology finance professor Andrew Lo, who is also a principal at
asset manager AlphaSimplex Group LLC. By the same token, if the
losses this summer drive some investors out of quantitative
strategies, it could be good for the quants that are still in the game.