Sunday, September 02, 2007

Thoughts on the Quant Crunch

Ok, maybe that's a bit extreme, I don't know that recent events in quant land can or should be called a crisis. Problematic - sure, especially if you're an investor in a fund that recently got hit. However, that's how this game works, right? There is inherent risk, no matter how much we attempt to mitigate it. Otherwise, we'd be discussing buying US Treasuries of varying durations, right? (Hell, there's risk there too but I really don't feel like attempting to have that discussion now.)

There was an interesting post recently over at AllAboutAlpha including interviews with professors David Hsieh and William Fung. Now, the part that grabbed me was the bit about the wide dispersion of a strategy giving rise to a factor or alternative beta. That is to say that when you have a small group of operators successfully using a strategy, the result is alpha generation. However, once that strategy becomes popular, the returns become due to alternative beta as opposed to alpha. I'll buy that.

Now, all of this discussion was taking place within the realm of hedge fund replication. However, the implications are pretty interesting. A crowded trade leads to alternative beta, thus shrinking the average returns that the strategy is responsible for. The once proprietary component of the model thus becomes yet another factor which can be included in a replicator's model. So now we start generating alternative beta without the need for the compensation overhead standard in the HF world. Why pay 2 and 20 for beta of any kind?

The moral of the story would appear to be that you have to keep those proprietary factors fresh. There are only so many original ideas; most success comes down to the execution of the idea. The quant analysts will have to keep constantly on their toes in order to bring new strategies to the table which can successfully generate alpha.

As for the matter of hedge fund contagion which has come up recently in many venues, it appears to me that the NY Times is off the mark. The illiquidity of investments in hedge fund portfolios caused those funds to sell off liquid investments in order to cover redemptions and margin calls. At least, its a reasonable guess that seems to fit the observations of hedge fund professionals who have commented on the matter. Maybe I missed something, but it looked like they were a bit wide on that shot.

As for this piece over at the FT, we again see the need for refreshing the prop factor pool, and I'm sure people smarter than me are looking at how to model the perturbations caused by all of those operators crowding a strategy. The last thing any HF operator wants is his prop factor to lead to alt beta, right?

In the end, it looks like a lot of quants got caught for various reasons. Some were probably legitimately in the wrong place at the wrong time. Of course, aren't they paid to be elsewhere at the wrong time?


This reminds me of Finbar's recent note wherein he said:

The nearest rebellion I have seen is when one of my quants on 16 August told me he was switching all the long and short signals because he knew all the other models were tightly correlated. He made the fund 13% in one day and is now the proud owner of a Porsche (which he sold as he doesn't have a drivers license and bought at auction an early IBM 86 PC with box and instructions).

Others probably were swimming naked when the tide went out. I guess time will tell who falls into each category. But everyone takes a loss sometime. I should know.

Time to get to work on my trading model...

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