Allocator Beware

Investors have little appetite for human portfolio managers these days. In the first quarter of 2017, $4.6 billion of new money was invested in quant funds, while $10 billion was withdrawn from non-quant funds, according to the Wall Street Journal. It’s been well documented that humans are having trouble beating the market, but it appears that machines aren’t doing much better.

Overall, quant funds, which use sophisticated statistical models often developed by Ph.D.s rather than trade based on human research and intuition to find attractive trades, rose 1.44% this year, through May, according to data-tracker HFR. That compares with a gain of 8.7% for the Standard & Poor’s 500 index and a rise of 5.7% for the Vanguard Balanced Index Fund, which invests 60% in stocks and 40% in bonds, highlighting how far quant hedge funds are lagging behind more traditional investments.

Quant funds have had trouble this year, but I don’t expect that to slow the gush of money that’s been coming their way. While beating the market is hard for humans and algos alike, there are a few things about machine driven investing that allocators find so attractive.

  1. Systematized strategies make it much more manageable to deal with bad performance. Even in an imprecise back test, you can expect to lose in 30% of three year rolling periods, for example. Knowing the base rate ahead of time gives investors a fighting chance at avoiding self-inflicted errors.
  2. With a rules based strategy, it’s easier to look under the hood and explain which inputs led to bad output. This is much harder to with subjectively run portfolios.
  3. Paulson, Ackman and other big name hedge fund managers have had struggles recently, and very publicly to boot. Sequoia’s large position in Valeant might be the straw that broke the camel’s back.

I don’t know when the inflection point occurred in the asset management industry, but it’s clear that stock pickers have been under assault for a while now. Perhaps the pendulum has swung too far, however, from shoot from the hip subjective to 100% rules based. Maybe there’s room to blend both styles, as Leigh Drogen and Patrick O’Shaughnessy recently discussed.

Active management isn’t dead because there will always be a large portion of the population who will never settle for “average” returns. The supply of money attempting to beat the market will never dry up, but with low cost alternatives, the industry is going to have to work harder than ever to hold onto their investors. Figuring out how discretionary inputs can improve on a purely quantitative system could be the next thing that investors go rushing towards.


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