Markets acting odd? Round up the usual suspects

Markets are hard to predict or explain. It helps to have some usual suspects to round up when all else fails.

It’s tough to be an equity analyst. Markets are hard to predict or explain. It helps to have some usual suspects to round up when all else fails, and one of the most usual is quantitative funds. Many people are suspicious of mathematics in general, probably because they find it mysterious.

A recent Wall Street Journal article blamed low stock market volatility on “revenge of the quant funds” while Goldman Sachs Group Inc. said quant funds were causing increased volatility. Then an analyst at the firm warned that quant funds were about to sell stocks, while the Financial Times said quant buying was propping up equity prices. Meanwhile, a strategist at Deutsche Bank AG estimates that quant and fundamental investors haven't been this divergently positioned since 2019, but an article in IPE argues that the two are working in tandem to weaken the link between volatility and prices in equity markets.

The reason such varied explanations can be supported is that there are many different types of quant funds. Momentum funds can increase volatility by buying the things that are going up, and selling the things that are going down. Value funds can do the opposite by buying stuff that has gotten cheap, and shorting stuff that has gotten expensive.

But both these explanations are grossly oversimplified. For one thing, there are many varieties of strategies. A momentum fund might also look at sales, earnings and other types of momentum besides just the price of an asset. It might consider absolute momentum or momentum relative to industry, country or other groupings. It’s not necessarily true that momentum funds are net buyers of stock when the S&P 500 Index is going up. Moreover, quant funds look at data over longer periods than most market analysts. The articles cited above were generally considering a couple of months of data, while quant funds are often calibrated over many decades and might focus primarily on data intervals of a year or longer. Strategies often include some shorter-term data as well, but its impact is diluted by medium and long-term data.

Another point is that most quant funds are run in a way that minimises market impact. Many are managed to set betas, or exposure to the market. Long-only quant strategies, for example, are generally run to a beta of 1, like index funds. An index fund gets a beta near 1 by buying all stocks in an index, a quant fund by carefully selecting a portfolio that will match the market performance with – hopefully - a small edge in performance. But in both cases that means a constant exposure that should not affect overall market prices or volatility. Another large group of quant funds are run “market neutral,” or zero beta, and similarly should not affect prices.

A popular focus of complaints is volatility-targeted quant funds. In the attempt to get a constant volatility these funds will increase exposures when market volatility is low and reduce exposures when it is high. Some analysts claim this can make markets unstable, but there are two problems with this argument. The first is that the funds are both long and short. That means when funds change exposure, they’re both buying and selling stocks, and should not have a gross effect on market prices or volatility. Second, these funds typically use sophisticated volatility predictions incorporating a lot of data. They do not react wildly to day-to-day fluctuations in the Chicago Board Options Exchange Volatility Index - better known as the VIX - or one or two month realised volatility.

Two other reasons make quant funds unlikely suspects. One is that they are reasonably small. Hedge Fund Research estimates that quant hedge funds manage $1.13 trillion, which sounds like a lot, but in reality includes many different kinds of funds in many asset classes. If you consider only directional equity quant hedge funds, they’re a negligible fraction of the more than $100 trillion in global equity markets, even if they all traded in lockstep. Second, quant funds are the least mysterious investors in the market. They make decisions by clear algorithms, not unpredictable human psychology. Anyone seeking to blame them for some market event should have no difficulty in demonstrating how the algorithms led to the event.

None of this is to say that quant funds never affect markets. Portfolio insurance algorithms played a part in the stock market crash of 1987, and they were entirely responsible for the quant equity crash of August 2007. Quant funds sometimes employ high leverage and active trading, and therefore can punch above their weight in terms of assets under management. But these are cases of specific types of quant funds contributing to specific market events in well-defined ways, not blanket appeals to round up the usual suspects.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. Views are personal and do not represent the stand of this publication.

Credit: Bloomberg