A Year Later, Quants Aren't As Susceptible To Meltdown
August 27, 2008: 04:09 PM EST
NEW YORK -(Dow Jones)- "OK Computer": It's the name of a notable 1997 Radiohead album, and would also be an apt title for quantitative hedge funds' performance since their near-collapse last August.
While quants are outperforming the overall stock market year to date, their returns are in the red. Still, compared to early last August, when margin calls forced many big-name shops to sell stocks they held en masse, things could be worse than just "OK."
The problem last year was many quants' computer models favored the same stocks. When things got bad, many were forced to sell the same stocks at once, driving prices and returns down sharply.
Now, there's less of a correlation between the portfolios of big-name quant shops like Renaissance Technologies and AQR Capital Management, filings show. More importantly, quants and other funds have less leverage than they did last year, so forced selling hasn't been a problem.
What could be a problem, though, is a disconnect in large-cap companies' valuations, a key criterion for many quant models.
Quant hedge funds were down 4.63% this year through July, according to data from Hedge Fund Research. However, if you take out a miserable January, quants are slightly up for the year. Hedge funds overall were down 3.54% through July. The S&P 500 Index was down 13.8% through July.
Quant funds are "not having as tough a year as last year, but they're still having a tough year," said Charles Gradante, co-founder of hedge fund of funds and advisor Hennessee Group.
The recent flattening out of what had been a down market doesn't help quant funds, surprisingly. "The quant strategies need a trend: Either a bull market or a bear market," Gradante said. Recently, the Dow Jones Industrial Average has been in the 11000-12000 range.
July was a rough month for quants, as they lost 1.49%, according to Hedge Fund Research. The funds Hennessee invests in got caught going long financial stocks and short energy stocks, probably because models showed financials as undervalued and energy stocks as overbought.
At the start of August a year ago, many quant funds were hurt by their leverage, or use of borrowed funds to increase their portfolios. A decline in stock prices led prime brokers to force hedge funds to meet margin calls - one of the risks of using borrowed money to invest. In a margin call, an investor has to deposit cash with a broker to cover declining investment positions. In order to meet the margin calls, the funds had to sell stocks.
Many top quant funds actually recovered from their awful start to August, but the severe hiccup caused many to change their way of investing. Most funds have had much lower leverage since then.
"They can weather the storm - i.e. volatility - without having to be forced to sell," Gradante said.
Last year, in a short period of time when the stock market fell less than 5%, quants fell much further. AQR lost 13%, Renaissance dropped 8.7% and a fund run by Goldman Sachs Group Inc. (GS), Global Equity Opportunities, fell 30%.
While the average quant fund hasn't made money this year, it's certainly better off than during the August sell-off last year. Goldman was able to raise more money for the Global Equity Opportunities Fund, and it was actually up 7% through the middle of June.
And in a year where generating double-digit returns in any hedge fund is nearly impossible unless it's dedicated to short selling, some quants are defying odds.
The DKR Quantitative Strategies Fund, a $300 million fund run by Stamford, Conn.-based DKR Capital Partners, was up 13.32% for the year through July 25, according to investors. Other hedge funds run by DKR, a subsidiary of AIG International Group Inc. (AIG), use different strategies.
Like DKR, many hedge fund firms use quantitative strategies as only part of their operations. That makes it difficult to make a blanket statement about how their quant models are faring. And it's unfair to blame everything on the computers.
Bruce Kovner'sCaxton Associates runs global macro funds, as well as equity funds, all of which heavily use quant models. When it had trouble last August, Caxton started placing a little less emphasis on quant strategies. So far, the results are a bit less than "OK," especially for an industry superstar like the billionaire Kovner, a former Goldman Sachs trader whose 25-year-old shop runs more than $10 billion.
The Caxton Alpha Equity Fund was down 8.65% through the beginning of August, according to investors, after gaining 12.2% in 2007. Its flagship Caxton Global Investment LTD Fund was up 3.58%, after finishing last year up just 1.14%. The fund was hurt in the second half of last year by investor redemptions.
And of course, the challenges aren't over. Satya Pradhuman, director of research at Cirrus Research, said his firm has found that valuation models, which quants often use to figure out if a company is overbought or oversold, aren't matching up with what's happened in the past. For instance, the Russell 2000 Index was down 4.4% compared this year through July, compared with the S& P's double-digit loss. The Russell 2000 includes more small- and midcap stocks than the S&P 500.
Usually, in a down market, it's safer to own large-cap stocks than small-cap ones.
But now, "the markets have shifted enough where the penalty of owning small caps is reversed," said Pradhuman, whose firm analyzes small- and midcap stocks.
The lesson that many quants have learned, according to Hennessee's Gradante, is pretty simple: Don't just listen blindly and think the computer is right.
"The quant guys," he said, "will superimpose some fundamental analysis."
- By Joseph Checkler, Dow Jones Newswires; 201-938-4297; joseph.checkler@ dowjones.com |
