2018 was a horrendous year for many quantitative funds and their investors (I speak from personal experience). Although I do not wish to add to the commentary on the drivers of this particularly difficult period, it has brought into sharp contrast how different owning a systematic strategy is to holding a fund with a more traditional, human-led investment approach. Whilst both sets are often rightly grouped under the active banner, this definition belies the specific behavioural challenges investors face when holding a quant strategy – particularly when performance is poor:
Nobody Else to Blame – I have written previously about active fund investors suffering from a form of reverse disposition effect, that is a propensity to run winners and cut losers (unlike individual stock pickers). This is because fund selectors benefit from an attractive form of optionality – if the fund we have chosen delivers outperformance then it is due to our superior selection skills, whereas if it struggles we can claim that the underlying fund manager is behaving in a manner that is inconsistent with our expectations (a healthy dose of outcome bias is also at play here). This argument, however, does not hold for quant funds – in most cases we are investing in a defined system or process, if the strategy fails then it is far more difficult to apportion responsibility elsewhere – the process hasn’t changed, you picked it and it didn’t work. Unlike qualitatively driven funds, there is no get out of jail free card.
Curse of Consistency – Somewhat ironically, the majority of quant funds possess characteristics that are consistent with what most fund selectors say they seek in traditional active managers – a clear philosophy and a disciplined investment process / decision making structure that will be applied diligently through varying market conditions. Unfortunately, whilst prudent on paper, the stated preferences of most fund selectors do not really hold under stress. When active funds suffer marked underperformance the reaction of investors is typically not: ‘I’m a glad you are remaining faithful to your process through this difficult time’, but rather: ‘things are going wrong, show me what you are doing about it’. This attitude is a major problem for quant funds as in most circumstances their reaction to poor performance should be to consistently apply the process on the basis that it will deliver over the long run. A strategy doing the same thing when it is not working for a sustained period is often unpalatable for investors, even if it is the right approach to adopt.
Does the Factor Still Work? Perhaps the most significant problem for investors in quant funds pertains to factor based strategies, which are seeking to exploit market anomalies to deliver a risk premium. Owning such strategies requires a belief that the underlying factors exist (are robust) and will persist. It is this latter point that is the most challenging. Given that we can never have certainty why a particular factor has delivered a premium (we can only opine), we can equally never be sure as to whether it will continue to work. Perfectly valid factors can struggle for long spells and it is difficult / impossible to decipher whether these are the result of a structural shift extinguishing the factor premium, or a ‘temporary’ phenomenon. This uncertainty makes the task of myopic investors persisting with such strategies particularly difficult. Even if we pick the right factors we will have to sit through long periods when everybody is telling us they are broken.
Good Decision / Bad Outcome – Most quant funds are structured based on decision rules / algorithms that deliver on average, when applied over the long-term. By definition, this means that there will be phases when they do not and, with a liberal dose of leverage applied, these can be painful. Even a strategy with a high Sharpe Ratio, investing in proven factors, is prone to experience drawdowns that can be multiples of the long-term expected volatility. Averages hide a multitude of sins, and sensible decisions can come to look anything but.
Black Box Stigma: Quant funds unquestionably carry a stigma. They are blamed for a variety of ills, including (simultaneously) subdued market volatility and extreme bouts of volatility (apparently severe short-term market declines only began occurring with the onset of algorithmic trading). Of course, we should never invest in something we don’t understand – but this applies to all types of strategies. How much do we really know about the genuine drivers of decision making in a human-led investment process? Is the behaviour of a systematic trend following strategy more opaque than a discretionary global macro manager?
Discussing quantitative funds into one homogenous group is not particularly helpful and obscures the sheer array of approaches that can be broadly classified in this cohort. Each strategy should be assessed on its own merits – there are bad quant strategies as there are poor qualitative strategies. Investors, however, need to be acutely aware of the distinct behavioural challenges that arise from owning systematic strategies and be prepared to manage them if they are to successfully invest in such approaches.