Staying The Course Amidst This Relative Valuation Reversal

The quant fund liquidations of the last couple weeks distorted relative valuations. Overvalued, shorted stocks were bid up due to short covering, and cheap stocks were oversold due to aggressive selling. Now, the performance is reversing, and quant long/short funds are seeing big gains, which might continue as they retrace their losses and if no more panic trading occurs.

Looking at how market neutral funds performed speaks volumes on how, in the near term and during a crisis, correlations can increase and solid strategies can fall apart. For a quick primer of these strategies, realize that market neutral funds have minimal market correlation, so they earn their returns from the performance spread between their longs and short positions. Say, for example, a fund expects to earn a 4% annual long/short spread. Add to that an interest rate from the short sale proceeds of T-bills less some haircut, call it 4%, and the total return expectations of the strategy are about 8%. The risk, or annual variability of the long/short spread might be around 6%, and interest rates have their own volatility, so all in the expected risk for the strategy might be around an 8% standard deviation.

To bring those numbers into daily perspective, the expected daily return would be about 3 basis points with a daily volatility of about 50 basis points. So, gains or losses on a daily basis should roughly swing between -1% and +1% 95% of the time. However, we saw some daily losses of over 3%, or at least a 6 sigma event, and recently the gains have been over 1% daily, for several days running. Again, wildly uncommon occurrences (let's not quibble about non-normal distributions).

Everyone wants to fault the strategies, or the risk controls used, but some of this is a matter of time perspective. If, by the end of the month, most of these funds earn back their losses, then their month to month performance will be unremarkable. Though it is true that if you lose too much, too quickly, you can go out of business, the flipside is if you don't panic, and stay the course, you weather the turbulence and continue on with your investment objectives. Looking at performance over certain time periods can be quite arbitrary anyway.

One huge advantage of quantitative strategies is they strip emotion out of the investment process. In fact, they earn their returns by exploiting the mispricings of stocks due to emotion. The recent emotions triggered by the extreme outcomes have to be resisted, since the distorted prices will reverse, losses will be recouped, and over time the strategies will generate their diversifying returns. The bottom line is to stay disciplined and ride this thing out.

Comments

[wixeywaxy:]

All this baloney about market neutral funds is just that. It reminds me of the economist who were predicting the economy on the basis of sophisticated matematical econometric models. It sounded great and ordinary human beings weren't supposed to question the erudite. As it turns out the predictions were a disaster and no one anymore gives that approach any credibility. We'll see how many of these hedges have successfully established market neutral positions. My guess is that it will turn out to be near zero and the investors in these funds will take a bath. Vic.

2007 Aug 24 11:08 AM