A growing number of quantitative equity managers are striving to match their computer models to changing market environments better as they fight to reverse the performance drought they've been in since the start of the financial crisis in mid-2007.
A growing number of quantitative equity managers are striving to match their computer models to changing market environments better as they fight to reverse the performance drought they've been in since the start of the financial crisis in mid-2007.
Before the crisis, the weightings that quant firms allocated to the broad components of their alpha models for factor-driven strategies were “pretty static,” said Soonyong Park, a managing director and head of global portfolio solutions at investment consultant RogersCasey LLC.
At the height of the crisis, however, many found the performance hit from short-term volatility simply “too great to bear,” he said. As a result, more firms are working now to make the factor weightings “conditional on the market environment,” Mr. Park said.
Industry veterans predict that those efforts could result in a clearer division of winners and losers than was apparent during the halcyon years leading up to the crisis. Back then, the value and small-cap-equity signals favored by the majority of quant firms paid off broadly in terms of both strong investment gains and heavy net inflows.
Another development cited by some observers is a decline in public debate about the factors that quant managers are incorporating into their models, reflecting greater efforts to preserve competitive advantages as long as possible.
In mid-May, executives at BlackRock Inc. — the bond giant that became a quant and index behemoth as well with its December acquisition of Barclays Global Investors — said that they were working to make their models more flexible.
Blake Grossman, vice chairman and head of scientific investments at BlackRock, wrote in a letter to clients and consultants that the firm is “shifting our approach from relatively static tilts toward more dynamic portfolio positioning suited to the specific market context.” The move is one of several “enhancements” aimed at ensuring strong investment performance in the future, he wrote.
BlackRock has faced some difficult times with its active quantitative-equity business, which oversaw $144 billion as of the end of last year. Several of BlackRock's biggest “alpha tilt” quant offerings — including its $17 billion Alpha Tilts Fund (2% risk), its $6.6 billion Russell 1000 Alpha Tilts Fund and its $4.2 billion Russell 3000 Alpha Tilts Fund — trailed their benchmarks for the one-, three- and five-year periods ended March 31.
Rather than a prolonged stretch of underperformance, however, it was 2007 — when a number of its strategies underperformed by 4 or 5 percentage points — that weighed down the three- and five-year numbers. Many of those strategies outperformed their benchmarks the following year as volatility was peaking.
Ken Kroner, who last month was named BlackRock's chief investment officer and head of scientific active equity, declined to provide details about the changes in the firm's active quant business.
Investment consultants said that the broad pressures facing quant managers now have led many to implement — or consider implementing — similar moves.
“There were a number of managers that had relatively static models three years ago that are more dynamic today,” said Keith H. Black, an associate with investment consultant Ennis Knupp & Associates Inc.
INTENSE EFFORT
Quant giant State Street Global Advisors, which reported $86 billion in active quant equity strategies as of March 31, is one of them. Global chief investment officer Richard Lacaille said that SSgA has made a “pretty intense effort in the last several years” to study how “different parts of our evaluation process behave” in different market environments.
SSgA introduced some changes at the end of 2008, finding some “interesting evaluation signals that work at certain times very, very well” but prove much less effective at other times, he said. Those changes appeared to help the firm's active European quantitative equity strategy rebound strongly last year, though the results have been less dramatic in other geographic regions, Mr. Lacaille said.
SSgA's Europe Alpha Equity Strategy outperformed the MSCI Europe Index by more than 5 percentage points last year after lagging by 1.7 points in 2008 and 4 points in 2007. That helped lift its annualized return for the three-year period ended March 31 to -0.68%.
SSgA will continue to research the topic, said Mr. Lacaille, who predicted that attempts to make models more adaptable to changing market environments will likely become “more important to us in the future.”
The prospects for benefiting from adjusting quantitative factor weightings to account for a shift in market environment could depend on whether those shifts are “reasonably stable over the medium term,” Mr. Black said. For example, if it takes three months to adjust the portfolio, and the shift in market leadership doesn't last that long, there is just as much chance that changing weightings could hurt performance, he said.
Quant veterans predict more firms will move toward making computer-based models more flexible.
“I think it is the direction all quants are going,” said Churchill G. Franklin, executive vice president and chief operating officer of quant firm Acadian Asset Management LLC, which reported $49.4 billion in quant assets as of March 31.
And for a group of managers whose underperformance between 2007 and 2009 left them open to criticism that their models were all picking the same stocks, “it has the potential to add greater differentiation, as some will get these [models] more or less right, and some will get them wrong,” he said.
Yet another factor leading to greater dispersion could be greater efforts by quant firms to protect their secret sauces. One trend being seen now, Mr. Park said, is that “these firms no longer publish about their factor insights.”
Being more secretive is one means by which managers can try to combat the “crowding-out effect” as competitors figure out — and exploit — the same factors those managers are using to add alpha, Eric J. Petroff, director or research with investment consultant Wurts & Associates, wrote in a December paper. “The problem here for investors is the conundrum of needing to be ignorant of how their chosen manager proposes to add value, while at the same time forming an educated evaluation of their ability to do so,” he wrote.
Douglas Appell is a reporter at sister publication Pensions & Investments.
