It looks like the mainstream financial media is finally paying to the most important financial dynamic occuring right now: the quant bloodbath. Bloomberg this morning talks about how well value funds have done recently, in sharp contrast to many quant funds. This report concentrates on momentum funds, which are down big time over the recent rally:
Companies with the most debt and lowest returns on assets are turning the biggest six-week rally in stocks since 1938 into a bloodbath for last year’s best- performing trading strategy.
Investors in so-called quantitative momentum funds — which speculate that the worst stocks in the past 12 months will continue to decline — have become this year’s biggest losers after banks and companies that rely on consumer spending surged. Quant momentum managers may have tumbled 27 per cent this month in the U.S., the most since at least 1993, while those in Europe may have lost 20 per cent in March and 24 per cent in April, according to data compiled by JPMorgan Chase & Co.
“Not in a million years would we have expected this gyration to be as vicious and enduring as it has been,” Steven Solmonson, the head of Park Place Capital Ltd., a hedge fund that oversees $150 million, said in an interview from New York. “The quants got whipsawed badly.”
So why should we care about this? In part, it’s because of the huge role quants play in the markets. They tend to be high frequency traders, providing lots of liquidity to the markets. This liquidity, in turn, increases the effeciency in the markets, making them better able to reflect the information available to the broad markets. The government’s role in the credit markets, particularly offering subsidies for purchasing “toxic” assets and guarantees for bank debt, may be distorting capital markets, pushing fund managers to allocate money in ways that greatly diverge from any historical trends.
For now it seems that most of the quants are betting that this will come to an end. The market “misbehavior” encouraged by government led distortions will eventually correct itself, perhaps as early as sometime in the next couple of weeks. Some quants, however, may be delevering and withdrawing from the market in order to wait until markets begin to normalize again. This could diminish liquidity, and therefore market effeciency. Markets would be expected to become more volatile once again.
Our friend at ZeroHedge says we’d better hope for the market to correct soon. He thinks that the dislocation of quant strategies has the potential to break the markets, leading to huge ineffeciences and worse.
We are at a critical crossroads for the future of efficient markets. If the bear market rally persists, Bill Miller and 401(k) holders will be happier temporarily, however the end result would be a broken market. Readers who took offence to the photo of the Challenger explosion earlier, should wake up and realise that we are on the verge of the very same event occurring within the fabric of the free and efficient market system. The threat to the equity markets is not being exaggerated. If the powers that be are intent on raising stock prices one day at a time continually, then even as retail investors enjoy another day of moderate gains, in a few short days/weeks markets will reach a point of no return, and the resultant collapse in confidence in the free market system will force the majority of investors to forever depart from investing in equity markets.