My thesis has been the quantitative hedge funds really have changed the nature of the markets and trading. The most successful and famous is Renaissance Technologies, led by Jim Simons. The track record of success there has been fantastic, and it's all computer driven. Success begets copy cat behavior - and a flood of funds trying to replicate the grand chief have been born. Hence when I refer to "algorithms" dominating trading, I am speaking to this bevy of pooled capital, all doing (or trying to do) almost the exact same thing and taking stocks farther (both higher and lower) than makes any logical sense. And this, in my opinion, is simply crowding out people who use fundamentals or logic. The machinations of August 2007 really was the first time this hit me in the face as I was seeing action that were in no way explainable by any reasonable data point. Much of it was "liquidations" i.e. hedge funds over levered and much like an individual investors gets a margin call - so did they. So they had to sell what they could, not what they wanted to as many hold esoteric positions that had no market (hedge funds don't just own simply stocks and bonds). So they sold off the liquid parts of their portfolios. And once a selling begins, a waterfall effect hits as technical conditions are triggered in computer after computer throughout New York City (and in fact the world) and you get this cascading effect. A crushing selloff. The NyTimes actually had a good piece from a year ago (I remember because I had just started the fund and was getting similarly crushed to the current period)
- On Wall Street, there is a rage against the machine. Hedge funds with computer-driven or quantitative investment strategies have been recording significant losses this month.
- The managers of these funds are the products of the trading desks of the big investment banks, like Goldman Sachs and Morgan Stanley, both of which have investment operations that use computer models.
- “These guys all know each other, and they all have the same strategies,” said Ernest P. Chan, a quantitative trading consultant who has done computer-driven research at Morgan Stanley and Credit Suisse. “They came from the same schools, and they get together for drinks after work.”
- As the quantitative system has come to underpin the investment approaches of some of the largest hedge funds, its use has grown sharply.
- Moreover, bankers and investors say, the strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility and, for some hedge funds, has led to losses in the last month.
- Mr. Chan said this predilection for lemming-style buying or selling from investors using similar computer models could turn what would normally be a market setback into a wider contagion. “If all the models say buy, who is going to say sell? There is just not enough money on the other side,” he said.
- Despite the large sums of money involved, ranging from $250 billion to $500 billion, according to industry estimates, the club of quantitative investors is a small, exclusive one that bridges the trading desks of investment banks and some of the country’s largest hedge funds.
- Hedge funds as a whole have grown exponentially and now manage about $1.7 trillion, more than double the amount five years ago.
- But such strategies rarely promise high returns, so quantitative investors have broadened their computer models to include strategies for investing in more risky areas like mortgage-backed securities, derivatives and commodities.
- “You can build a computer model for anything that is tradable,” Mr. Chan said
- With many of these new assets being highly illiquid and with the funds themselves having used considerable amounts of borrowed money to enhance their returns, losses have been magnified as worried investors have demanded to pull their money out.
One might argue - but hedge funds still control far less money then mutual funds (or pension funds) so why the fuss? Again it all has to do with trading volume - mutual funds are generally slow moving turtles who don't make massive daily transactions... so they control a lot more money but if there is little VELOCITY of money (moving in and out) who cares how much they control? As I wrote a few weeks ago:
We are just mice dancing between the elephants of capital and their super computers. Just this past week, we found out that hedge funds have passed mutual funds in terms of volume of equity trading, despite controlling far less money. This is their era and the "marginal consumer" dictates the price - and they are the marginal consumer.
So I write this as my thesis, which Jim Cramer wrote a piece about last night echoing such thoughts. If anyone knows it is his him, because for all the criticisms he has run a hedge fund, he knows the players, he lives - breathes this industry. I am copying his piece below because when I say it, it sounds like excuse making, but truly this is not an investors market in my opinion and the only success nowadays is guessing what the computers will be apt to do. My hope is this is a relatively short condition (quarters/a few years) being exaggerated by a bear market. My fear is this is a permanent change in the future. If so, what we've grown up learning on how to invest is essentially on the road to uselessness.
Quants and the Machines
Could this be the exact opposite of last year, when all of the quant funds were in the financials and destroyed, causing huge losses? That's what happened last August.
They were caught and killed. Now it seems that all of the quant funds are caught in agriculture, coal, gold, oil and copper. They are doing exactly what they did last summer, indiscriminate selling because it is what their models tell them to do.
They are not allowed to deviate from their models so they have to sell their Archer Daniels (ADM) and Potash (POT) and their Schlumberger (SLB) and their Freeport (FCX) at whatever price there is. That's what their models say, that's what they do.
I cannot explain it any other way than that it is what they did last year when they were caught long, then caught short, and they just sold and bought all wrong. I had thought they had enough money taken away from them that they would not be able to cause this havoc. I believe I was wrong.
The more I check around, the more I hear that it is mechanics, mindless selling by quant funds caught in the wrong stocks. I should have realized I had seen this pattern just last summer, in another thin market where you would see them come in and blast down and blast up theoretically immune to price but in actuality, there isn't even a "they;" there is just a machine and its order is to sell FCX, period.
Everyone sees these clowns coming but can do nothing about it, and they finish with a little time left to go and you can see what happens. Everything lifts. Of course they never finish. They can't. There are too many of them. They all have the same parameters. They can take a POT down 100 once their models say it is no good. Same with FCX. I bet their models say sell it from now until kingdom come.
For many days now, people have been puzzled about who would make such bad sales, especially those of us who actually care about basis and exit prices. The machines. And they are running amok again. Getting it wrong again. Soon we will hear of big losses in these funds again. Usual suspects.
But their clients are so stupid, no one will care. Sometimes you just have to marvel at how often Wall Street can fool people.