All Strategies Blow Up
We are a quantitative finance shop, right down to the ground. All of our portfolios are driven by supervised quantitative models with no discretionary intervention. As such, I was inspired to respond to a recent article on the risk of quant strategies, as I think the way our team approaches quantitative research diverges from how many outsiders perceive quant, and also from how many quantitative shops work.
This article was inspired by a blog post written by Dominique Dassault at Global Slant, so we’ve loosely organized our comments around that article’s themes. But be warned: we decided to take our comments in a materially different direction. Dassault concentrated on how ‘bad quant’ strategies ‘BLOW UP’, and how these events contribute to systemic risk. In this article, we will explain why even good strategies must test investors’ ReSolve every now and then in order to deliver long-term excess returns. We will address ‘good quant’ vs. ‘bad quant’ and systemic risk at length in a future article.
First, let’s define a BLOW UP. Of course, when most investors imagine a BLOW UP they picture large absolute portfolio losses. And this is certainly the most acute and meaningful type of risk, both from an emotional and a financial standpoint. After all, large losses impair a portfolio’s ability to sustain distributions, such as during retirement, or to support endowment or pension liabilities. But investors also find it hard to endure other types of portfolio outcomes, such as:
- Long periods of meaningful underperformance relative to widely observed benchmarks;
- Long periods of no returns, which cause investors to question the viability of the strategy; and
- Social exclusion, such as from owning so-called ‘sin stocks’ like tobacco and firearms companies.
Investors experience fear and discomfort from these and myriad other less tangible risks, and in their own way, each of these experiences can feel like a BLOW UP. However, while these risk qualities may feel as painful as real losses, they inflict much less financial damage to portfolios; falling behind for a while, or having a materially different experience than your peers, is not the same as losing 30% to 50% of your money when it comes to sustaining portfolio objectives over the long-term.
But here’s the rub: without occasional highly unpleasant periods, investors could not expect to earn any excess returns over safe cash. To see why, consider the excess returns to stocks versus cash or bonds. An equity index, like the ubiquitous S&P 500, is a simple quantitative strategy which systematically holds qualifying stocks in proportion to their respective market capitalizations. But stock markets have historically BLOWN UP about every 5 to 7 years in the form of explosive bear markets. In return, equity investors are compensated for bearing this risk; this compensation is the called the ‘equity risk premium’. Many investors, who are not steadfastly convinced of the persistence of the equity risk premium, capitulate to fear and sell their stocks at the depths of bear markets. As Michael Batnick at Irrelevant Investor blog correctly pointed out, these people are the equity risk premium. They donate capital to those who are long-term true believers that equities will outperform.
We can expect the equity premium to deliver a persistent premium through time, so long as equity markets are expected to inflict regular BLOW UPs, which shake out weak hands. In fact, it is unreasonable to expect to harvest returns from the equity risk premium without enduring regular BLOW UPs.
Some investors try to attenuate the risk of the equity risk premium by timing exposure to equity markets in order to avoid the inevitable large drawdowns during bear markets. Many of these investors believe that they are investing in the equity premium, but this is not strictly true. Rather, these investors are harvesting some returns from the equity premium, and some returns from other market anomalies.
For example, investors who try to time equity markets by moving out of equities when they appear expensive relative to historical averages or other asset classes are, perhaps unwittingly, attempting to harvest the ‘value’ factor. That is, they are trying to overweight cheap assets and underweight expensive assets. Similarly, many investors try to manage equity exposure by employing moving averages or other technical indicators. In fact, these investors are, whether they know it or not, attempting to harvest the momentum premium. In other words, they are taking advantage of the fact that markets ‘trend’.
Investors who attempt to take advantage of alternative sources of risk and return, such as value or momentum premia, should not be under the misapprehension that they have successfully avoided risk. If that were true, they would have also successfully avoided excess return! Rather, investors in these alternative premia have simply substituted one risk for another.
One risk that both value and momentum premia exhibit is the risk of under-performing the assets being ‘timed’ for extended periods of time. This can be quite painful for investors, as they watch their friends’ more traditional portfolios appreciate while their portfolios stagnate. As a result, investors become infected with the suspicion that the factors they are harvesting are somehow ‘broken’, or no longer exist. This fear and doubt compels many investors to abandon these strategies toward the tail end of under-performing periods, leaving money on the table for more disciplined investors to reap. If these unpleasant periods did not exist, everyone would follow the strategy and no one would abandon it; thus no one would leave behind any excess returns!
If you are finding all of this confusing and counter-intuitive, you’re not alone. But this is precisely the kind of second and third-order thinking that is required to be a successful investor. The point, however, is that all investment strategies that are expected to deliver long-term excess returns must be expected to very seriously test your ReSolve on occasion. These tests are mostly unpredictable, but sometimes can be attenuated with subtle quantitative techniques. We will discuss good and bad techniques, and potential systemic impacts to markets, in a future article.