I had breakfast with a friend who happens to be a quant. A very good quant, in fact. As he began sharing his thoughts concerning his own strategies in light of today's environment, I found that they squared pretty much with my own.
Clearly, a massive de-leveraging had taken place, and quants were running far less levered strategies than they had previously. Further, quants are beginning to place greater emphasis on high-frequency trading, strategies that place far less capital at risk and require much less balance sheet than approaches with longer signal horizons.
Problem is, of course, that when quants pile into the high-frequency, statistical arbitrage, quasi-market making space, it becomes very crowded very quickly. This style of trading is far less scalable than more systematic, longer-term strategies, and returns get crushed much faster as new capital enters.
So what will happen? Before long high-frequency trading will become too crowded, placing downward pressure on returns. Returns can be bolstered one of three ways, either by (1) introducing better returning, but riskier and more capital intensive longer-dated strategies, (2) increasing leverage, or (3) extracting value from completely new and untested data sets. With many quant funds getting killed in 2007 due to leverage and crowded trades, I find it hard to believe that they will choose option 2. But given current (and expected) high levels of volatility, will quants (and their risk managers) have the stomach for longer-dated strategies? Maybe more calories will be spent on alternative data and approaches, trying to find new ways to capture edge in a busy landscape.
It is a confusing time to be running money, especially using quantitative approaches, where recent events create statistical outcomes so out of step with the past that historical analysis is of limited value. It is not a question of analyzing and managing a handful of stocks in a long/short portfolio, but of coming up with models and frameworks that can be applied to hundreds and thousands of names, all at once, in real-time. So where do you hang your hat? What are the new paradigms that will enable market-beating quants to emerge? Is it new paradigms or new data sets that will lead quants forward to better times? I would bet that it will be a combination of the two. And if history is any guide, a handful of quant funds will emerge from the ashes as market-beaters for years to come.