Why Quant Strategies Are Struggling

Art by Jon Han

Quantitative funds usually depend on trends. But one quick change in the weather, and that trend is gone. A lot of that is going on lately.

The idea behind quant funds is that brilliant strategists and their computers can construct mathematical models that yield smart ways to invest. Volatile markets and that dreaded condition called “unforeseen events”—such as markets jolted by sudden twists in the Sino-American trade war or random presidential tweets—are gravel in quant investors’ gears.

As a result, quant hedge funds are down 3.5% this year, versus an 18.5% advance for the S&P 500, according to Hedge Fund Research (HFR). And picking steady winners in this arena is not easy. “Many trend-following hedge funds are inconsistent from one year to another,” noted Yung-Shin Kung, who is head and CIO of Credit Suisse’s Quantitative Investment Strategies group. “Very few maintain steady top-decile performance through the years.”

Small wonder that hedge fund categories that typically are strong quant strategy users haven’t covered themselves with glory. Managed futures, for instance, are up a paltry 3% in 2019, after a 6% slump last year, according to eVestment researchers. Touting their lack of correlation to traditional asset classes, these creatures usually use derivatives to bet on an array of markets, from currencies to commodities like agriculture. Turns out that volatility has periodically stuck its snout in everything these days, making managing them harder, and rendering smart bets not so smart.

Among quant mutual funds, a mere 17% beat the market in this year’s first half, a Bank of America Merrill Lynch Global Research report indicated. Columbia Threadneedle and Neuberger Berman have closed funds, saying they were too small to get any traction. The AQR Market Neutral fund has suffered from investor redemptions amid its 8.5% loss this year following 2018’s 11.8% drop.

True, there have been winners in the quant field. Like Vanguard Growth and Income, which uses quantitative approaches it doesn’t disclose (beyond such broad ones as beta and momentum). It has managed to beat the S&P 500 for most of the last decade.

Despite their spotty recent record, quant strategies retain an allure, at least among institutions and other sophisticates, with such investors favoring them over more prosaic options. By HFR’s count, in this year’s first quarter, quant hedge funds had net withdrawals of just $1.8 billion and non-quants parted with $16 billion. On the other hand, once-popular quant mutual funds, which have more of a retail clientele, have been bleeding since 2018.

Quants’ performance woes likely have a lot to do with the value bent many of them have. Looking at the 29 largest quant mutual funds, which Lipper classifies as “quantitative core,” Bank of America found that their holdings have much lower multiples than their benchmarks. In other words, they’re value-oriented. But value has been in the toilet for some time.

And it’s not climbing out anytime soon. The theory behind value investing is that their stocks eventually will rise as investors discover hidden gems and their worth reverts to the mean. But thanks to hot tech and health care shares, which are the embodiments of growth stocks, there’s a gaping valuation gap between growth and value. And it’s the widest in 70 years, in price to book terms, says Sanford C. Bernstein research, with growth getting more expensive and value becoming cheaper.

Value is one of the factors on which quant managers focus. Other factors—like size (small stocks do better over time), momentum (upward movement tends to go on for a while), quality (low debt, stable earnings, and revenue expansion reassure investors), and volatility (the less, the better)—are part of the mix. But these ones haven’t delivered much either.

“Quant stock selection has been terrible,” said Cliff Asness, CIO at AQR Capital Management, one of the largest quant managers, at the Morningstar Investment Conference in May. “Factor investing has been crappy.” His flagship, AQR Multi-Asset Fund Class I, is up a respectable 15% this year, although it still trails the S&P 500 by more than three percentage points. What’s more, its five-year annualized return of 4% is less than half that of the S&P.

Indeed, factor investing has been a laggard for years, argued Rob Arnott and Vitali Kalesnik, partners in Research Affiliates. Their paper issued in February titled “Alice’s Adventures in Factorland” contended that factors have lost their oomph. Reasons: They are overused and thus their utility has been eroded, trading costs whittle down returns, and investor faith in the concept is overblown.

“Too many investors believe that creating a portfolio of factors will eliminate the extreme tail behavior,” they wrote, meaning the likelihood of a seemingly rare outcome happening (think of the financial crisis, which surprised a lot of people). “This is a dangerous misperception.”

Nowadays, tail risk too often wags the market. And that throws the quants off their game. Example: Markets earlier this year were cruising along on the blissful assumption that Washington and Beijing would resolve their trade tiff. Then President Donald Trump exploded their comfy notions by charging the Chinese with bad faith and threatening more tariffs. Now the two sides are going back to the bargaining table, but no one knows what will occur next.

If you were a quant, how would you model for that?

Nevertheless, none of this is to say that quants won’t have their moment to shine, at some point. In contraction periods for the economy and the stock market, when investors want to de-risk their portfolios, Credit Suisse’s Kung observed, two quant strategies—managed futures and trend-following—historically do well.

Hey, it’s about time.

Related Stories:

At Morningstar: Asness Has No Simple Answer to Quant Strategy Losses

Quant Hedge Funds Trail Old-School Ones, But Reap All the New Money

Profs vs Quants: Who’s the Better Investor?