A stupid question on the quants

This article is contributed by: QuantMinds

Summary:

In my personal website, I have done a pool to investigate the attitudes towards quantitative finance. A simple question was asked: Do you think Quantitative Methods are REALLY valuable to financial industry? To date, I have collected 103 data points, of which overwhelming 88 respondents answered “Yes”. I am working in a quantitative analytics position, [...]

Read the rest of this entry »

Matt Rothman, Barclays’ U.S. Equity Quantitative Strategy head in his most recent note, likens the underperformance in tracked quant factors seen on September 15th of this year, to that from August 9th, 2007. Those in the quant community vividly recall what happened then. Has the persistent push higher in market on no sustainable fundamental, technical or otherwise drivers at this point caused irreparable damage to traditional quant players, who have had no means of dealing with what, as Rothman points out, is merely a systematic annihilation of shorts.

A couple of questions around this:

First, before we asked a question such as “Is a Quant Unwind in process as the short squeeze hits a crescendo?” we should ask “Is a Quant able to predict a Crescendo?” first. Fundamentally, Quant models were failed in a turnaround market because it failed to predict the timing of the peak in market. The models were failed in direction of return will eventually drove the results inversely.

Second, we also need to know the Quant models failed to incorporate all government interventions quantitatively, which are highly interactive with investors’ sentiment.

In math world, academics often assume that practitioners are skeptical of models, as they should be. In the lead-up to the crisis, this doesn’t seem to have been the case. Models have their uses, and in an ever more efficient, faster-moving, interconnected and thus more volatile financial system they are indispensable tools.The models with the most simplest formulas and thus with the most restrictive assumptions remained the most attractive to practitioners and VaR (‘Value at Risk’) remained the standard metric for measuring risk, because it ostensibly allows the risk of a complex financial position to be expressed as a single number. Unwarranted simplification aside, the problem wasn’t as much the use of quantitative methods, as the seeking of inputs where there were none to be obtained reliably. To have at least some semblance of reality, the models must be calibrated to the market, so additional modeling assumptions were made up to a point where calibration was possible. Subsequently the oversimplification was forgotten – obscured by the illusion that something was rigorous and exact simply because it was expressed in equations. However, although we are likely to see more regulation of financial markets, the complexities of the global financial system will not go away. Models can help navigate these complexities and identify the pitfalls – which is helpful as long as the potential pitfalls are treated as such, and not glossed over by heroic assumptions when expedient. The bottom line is to calibrate to what you know, and stress test for what you don’t know. Risks which we can calibrate, we can manage and even hedge, while risks for which we can stress test, we can at least identify. Nevertheless, even calibrated models will only reflect the market consensus and therefore will not take into account risks currently not perceived by the market. In 2005 or 2006, the possibility of a crisis (beginning 2007) wasn’t priced in, except perhaps with so low a probability as to be negligible. The market did not predict the crisis, so a model calibrated to the market could not – and it shouldn’t be expect to.

Reference:

Why We Can’t Predict Financial Markets

And another article

Quantitative Finance: Felon Or Fall Guy? And Where Do We Go From Here?

From Rothman:

We are not believers in superstitions, the occult, conspiracy theories, sun-spots, or horoscopes. But the date September 15th certainly seems not to be a particuliarly good one. Next year, we are planning to be far away from the markets, hopefully on an island, without access to a Bloomberg terminal or the Internet.

We all remember the events of September 15, 2008; September 15, 2009 had nowhere near the same headline drama but ironically the performance of quantitative factors was considerably worse. This past Tuesday, we experienced large negative returns in all of our three major quantitative themes – Valuation, Quality and Market Sentiment.

Specifically, on Tuesday, our long/short Valuation index returned -1.45%; our long/short Quality Index returned -1.47%; and our long/short Market Sentiment Index returned -1.75%. These returns are statistically significant and represent 3.3, 2.9 and 2.1 standard deviation moves, respectively, in the factors. We have not seen such poor performance in all of our factors on a single day since August 9th, 2007. Indeed, we have seen this level of misperformance on only 29 other occasions since July 1950 (approximately 15,000 trading days). To be clear, it is not the magnitude of the returns that is so unusual. Rather, it is the significant perverse performance by all of our factors at the same time that is eye-opening.

Yesterday, we saw performance in our Valuation Index and Quality Index reverse, albeit somewhat tepidly, with +0.55% and +0.71% returns respectively. On the other hand, Market Sentiment continued its trend downwards, returning -2.35%. The “up day” in Quality is notable as it breaks a string of 9 consecutive down days for the index; this ties it for the 6th longest losing streak for our Quality Index on record. On the other hand, Sentiment’s losing streak is now extended to 9 consecutive days, tying it for the 13th longest streak on record.

And as for Rothman’s speculation on the causes of this peculiar move in factors:

It is hard to know what was the cause of Tuesday’s misperformance. The obvious candidate is that there was an unwinding going on by a major quantitative asset manager or multiple managers. Based on our conversations with the Barclays Capital trading desks and with numerous clients, we have no evidence to support this hypothesis. We cannot say definitively that someone somewhere wasn’t unwinding – we just have no evidence of it.

And when looking at reasons for the amazing market move since September 1, could it be explained as simply as yet another round of massive forced short covering, exacerbated by investors funnelling into the most shorted stock? The answer, apparently is yes.

Similarly, we find evidence that a short-squeeze has been occurring in recent days as investors also are flowing into names with higher short interest. As shown [below] since September 3rd, stocks with the highest short-interest outstanding have been consistently outperforming those stocks with the lowest short-interest outstanding. The uniformity in these returns across every quintile of short-interest is quite striking – short interest outstanding has been an almost perfect negative indicator of performance during this period. Additionally, over this same period stocks with the highest borrowing costs have been outperforming those stocks with the lowest borrowing costs. Again, the near uniform monotonicity of these returns across the quintiles is highly notable.