Looking back at 2007, August will likely go down in history as one of the most infamous months for market neutral quant strategies. While there is no shortage of opinions attempting to explain the causes of August’s volatility, one unifying theme is that quantitative strategies are not as safe as they were thought to be, a theory that initiated a cascade of quant strategy fund redemptions.
Many people believe August was proof no matter how sophisticated computer models become, they cannot predict movements better than humans relying on fundamental data, experience and intuition. Even though August was a unique event, the pattern of an unanticipated industrywide occurrence resulting in steep losses leads to the herd behavior that has plagued the financial services industry time and again. Cases in point: the subprime mortgage crisis and the bursting of the tech bubble. However, if one looks back at historical market crises, investors who benefited were those who used the crisis to their advantage by selecting winners from a sector suffering from negative perception.
One of the biggest challenges in evaluating quant strategies is the complexity and relatively opaque investment process. Therefore, when quant strategies were performing in line with their peers and the general market through much of 2007, it was harder to isolate the true alpha generators from the pack. For example, during the first 10 months of 2007, an average of 58 market neutral equity funds reported positive monthly returns according to the HedgeFund.net database. However, during the month of August, only 39 funds reported positive performance, far below the next lowest month of July when 47 funds reported positive returns. From that data, one can see how August was an opportunity for investors who wanted exposure to market neutral quant strategies to identify non-correlated and differentiated strategies which generate true alpha rather than beta disguised as alpha.
The August crisis was a welcome event for market neutral managers with unique strategies who were able to prove their thesis. As individual and institutional investors contemplate their allocations for 2008, it might be wise to conclude that now is the right time to allocate capital to funds unaffected during the recent crisis instead of simply redeeming from quant strategies altogether.
