QuantMare Case Study

Are you under stress?

Chances are the more levered up you are, the greater your duress. Thankfully you took a few chips off last week, although it was a less than opportune time to do so.

We tried to discuss the crowded trade that developed in many of the quantitative strategies last week. Our time spent battling small cap growth denizens left us with plenty of scars, but at least we learned something. Sometimes you have to get out of harms way. In the late 1990's momentum based strategies would pile into positions rather haphazardly. It was the golden age for mindless morons, and it would seem history is repeating itself.

Remember Pilgrim Baxter? Nicholas-Applegate at their peak? Driehaus at the top of his game? TCW? The mo-mo's would start piling in and you had to start thinking about when, and how, to get out. Because you did not want to be on the other side of the trade as they ran for the exits. The problem was, is that they all had similar strategies, and they were getting massive retail and institutional inflows that they had to put to work. And they were not shy about it. They could be sloppy on both sides.

It is not dissimilar to what we have recently seen with the quant shops. Consultants decided they were to the go-to guys, and handed them billions of dollars. The growth in assets at these shops has been staggering. Don't get me wrong, I have more respect for the rocket scientists of 2007 than I did for the reckless momentum investors prowling the street circa 1995-2001. And for better or worse the current crop will probably have more staying power.

But we will turn it over to this guy, who is more eloquent...

First, quantitative funds are highly levered........Second, they have strategies in common. This should not be surprising, given that many of these funds share a common lineage: Goldman’s Global Alpha Fund and AQR; Tyke and DE Shaw. The bread and butter strategies for many of these larger quant funds are momentum and stock valuation, with some factor-based allocation strategies sprinkled in. There aren’t a whole lot of different ways to measure momentum, so what one firm considers a high momentum stock is likely to have been similarly tagged by other firms in the game.

The same is true with stock valuation and factor strategies. Valuation is modeled using factors like free cash flow, earnings quality and analysts’ earnings estimates. While there may be nuances in how you do this, you can only twist these sorts of data around so much. So at the end of the day each of these funds will be long and short similar sorts of stocks – if not the exact same stocks......

Finally, in aggregate these quant funds may be operating beyond the capacity of the markets. Well, right now that is pretty much true by definition, since it seems they can’t get out of each other’s way while they try to liquidate. But even during less crisis-prone times, the money employed by these strategies might be more than the market can absorb. Rick Bookstaber

Indeed, all the quants are using variations of the same theme. And much has changed since I labored under a 4-factor model that was rolled out in the mid-to-late 1980’s that was one of the the first attempts at a robust, institutional level quality strategy. While our model did not include a measure for free cash flow yields, it might have been one of the attributes that attracted them to Deluxe Corporation (DLX-NYSE). We can’t be sure, of course, but they all owned the stock.

DLX Holders, descending order:

Barclays Global Investors
Goldman Sachs
Bear Stearns
Renaissance Technology
Highbridge
AQR
DE Shaw

No, we can’t be sure exactly what strategy offerings at the various shops owned Deluxe. It could have been fundamental guys too. But they were all in there. This list includes folks some from the end of March, and some recent filers from June 30th. Several of them could now be out too, judging by the volatile trading last week..

The stock had been on a steep ramp, attracting not only cash flow mavens but momentum junkies as well. And it was ripping while the quants all piled in. But like all games of musical chairs, this one came to an end. Perhaps some managers sold the stock as the valuation became less compelling.

Last weeks volume probably accommodated most of the sellers. The bounce on Friday capped off a volatile week for the stock, and people were looking for answers....

It’s amazing what fear and greed can cause a stock to do.

Last week, as the credit crisis caused U.S. stock markets to go haywire and nervous investors liquidated their positions, bargain hunting lifted shares in unexpected corners of the market.

Commercial printing stocks—including Deluxe , Consolidated Graphics and Ennis—soared Friday as a result of bottom fishing, perhaps by some of the big funds that use computer models to determine trading strategies. Forbes

Today, Goldman announced they are getting infusions of cash from Perry Capital and CV Starr. This will allow Goldman to ride out the move, as selling positions when you are forced to often turns out to be the low. Perry and Starr get instant exposure to equities that have been unnecessarily marked down, and if they buy more of the existing positions the move should work in the short term.

And if anyone was shooting against their positions, it might make for another mad scramble at the open.

You gotta love this game.

Goldman Global Equity Fund Gets $3 billion in Capital
Bloomberg

What’s Going On with the Quant Hedge Funds
Rick Bookstaber
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Quant-Mare (kwahnt-mair)
--noun
1. a terrifying or unsettling dream that results in a loss of sleep and poor investment returns when you wake up

2. an investment event that results in large losses after similar mathematical strategies fail to take into account real world considerations. Popular in Monte Carlo and Las Vegas. Although reputed to be rare, QuantMare’s actually crop up quite several times a decade

3. an investment that turns quickly sour due to factors beyond your control. Frequently an opportunity to raise fresh rounds of money
(origin:  1998 LTCM)
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The content contained represent the opinions of 1440 Wall Street. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author. No Positions

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