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Quant Shops Innovate to Survive

billy d

Baruch MFE, Class '11
Innovation has always been on the daily “to do” list of every quantitative fund management firm that uses computer programs instead of mortal analysts to pick stocks and bonds.

But after they were throttled by the stock market crash of 2008, quant shops ranging from behemoths like State Street Global Advisors to boutiques like AQR and First Quadrant stepped up the pace of their innovation in a bid to improve performance and regain the confidence of investors who have abandoned them in the past couple of years.

“The survival kit is, ‘Try to innovate,’” says Eric Sorensen, chief executive of PanAgora, a quant shop in Boston that is owned by Power Financial of Canada.

This trend is already starting to drive greater differentiation between dozens of quant shops in the US, many of which were seen to have been dragged down by strikingly similar momentum-oriented investment strategies that failed investors in the crash, notes Stephen Miles, a senior investment consultant at Towers Watson in London.

For institutional investors, the result will be a greater choice of investment strategies to choose from when they look to fill holes in their portfolios. This will lead to heightened competition between quant shops and, eventually, lower fees, Mr Miles predicts.

The quants have had little choice but to change their tune. Matthew Rothman, an analyst at Barclays Capital in New York, estimates that equity assets managed by quantitative managers in the US alone fell by 55-60 per cent from a peak in June 2007 to $483bn in December 2009, and that another $80bn-$100bn flowed out of quantitative equity strategies in 2010.

Momentum-oriented strategies – long favoured by the quants – performed badly in a crisis that was marked by inflection points at which market leadership switched from one type of stock to another, says Mr Miles. The software driving these strategies was not clever enough to anticipate the rapid switches from risk-on to risk-off, and from high quality stocks to distressed ones in the “dash to trash” that characterised 2009.

The underperformance of some quant managers may have been no worse on average than that of many fundamental bottom-up managers that employ human stock pickers, sometimes using computer-driven screens but still based mainly on their own judgment. But a lack of transparency that has long shrouded the investment models of quant managers – known in the industry as “black boxes” – has left enough doubt in investors’ minds to make their performance seem even worse than it was.

“For a lot of institutional investors, those managers and types of strategies really got a bad name,” says Kevin Quirk, a partner at Casey Quirk & Associates, which advises money managers. “They really face a bit of a headwind right now. They have got to go back and convince the market their models are more durable right now.”

So groups like SSgA, which is the second largest money manager in the US and was an early pioneer of 130/30 long-short strategies, are losing no time retooling their highly complex, multi-factor investment models.

After more than a year of back-testing, in January SSgA implemented changes to factors used in the investment model in its active small-cap equity strategy. The goal is to make the strategy more flexible and more capable of rolling with the punches in a tumultuous market.

Instead of using 30-year averages to calculate assumptions for short-term interest rates, which is just one of many factors the model uses to pick stocks, the model now uses shorter periods of time. As a result, the assumptions made in the model are adjusted more frequently, explains Alistair Lowe, chief investment officer for global equities at SSgA.

Scott Powers, chief executive of SSgA, anticipates no shortage of demand for the strategy, which has been renamed dynamic factor weighting, in the year ahead. “Clients are re-risking their portfolios. They are very cognisant that they need to reach their long term objectives,” says Mr Powers.

But there is always the risk that such adjustments could lead to other problems. “The most common pitfall of quants in this area is that a timing process is based on what would have worked historically and then the future turns out differently,” says Mr Miles.

Next, the quants will have to work on becoming more transparent before investors can regain confidence in them, according to Jeremy Degroot, chief investment officer of Litman Gregory, a financial advisory firm.

Litman Gregory withdrew its clients’ money from Axa Rosenberg, a quant firm that agreed to pay $242m to settle civil fraud charges with the Securities and Exchange Commission in February after disclosing that a “coding error” had cost its clients $217m. Even before that revelation, Mr Degroot says, he had decided to fire the group over its repeated refusal to disclose the inner workings of its “black box” – even though the firms shared the same office building in Orinda, California.

“We would ask a question about the investment process. They would say, ‘That information is proprietary. If we tell a client then our competitors will know what we are doing,’” recalls Mr Degroot.

(Axa Rosenberg chief executive Jeremy Baskin declined to comment on issues stemming from the coding error.)

Of course, a few quant shops openly discuss their investment processes with their clients, and have been making money for them every year even since before the crisis.

“To our clients, it is very transparent,” says Max Darnell, chief investment officer of First Quadrant. “Some of them want to know what is driving it at a granular level. We tell them everything about what we do.”

One First Quadrant strategy, dubbed global alternatives, actually gained 4.8 per cent in 2008, the year the S&P 500 Index fell 37.0 per cent. It was down 3.9 per cent last year but gained 7.4 per cent for the month of January.

Mr Darnell attributes First Quadrant’s performance partly to recent innovations. The group entered last year with a new active commodities investing programme and other new ideas that he anticipates will come in handy this year.

“Potentially, 2011 could be as volatile as 2010 was,” says Mr Darnell. “You can never tell where it is going to come from.”