April 08, 2008

The concept of "alpha" describes a value-add that measures how much an active manager can outperform his or her benchmark, thereby showcasing his or her investment management skills. The pursuit of alpha is a never-ending game for the securities and investments industry. Quantitative analysis was designed to achieve alpha like nothing before it. However, while the strategy largely has succeeded in its goal of achieving alpha, it does have certain drawbacks.

The world of quantitative funds always has seemed shrouded in mystery. Once in a blue moon the rest of the financial industry gets a glimpse into the actual mechanics of the quant world; though a direct view typically occurs because something has gone horribly wrong. One case was the sudden collapse of Long Term Capital Management (LTCM) in 1998. Another occurred more recently. In August of 2007, portfolios of multiple well-known quant funds fell by double-digit percentage points. Even the investment powerhouse Goldman Sachs took a huge publicity hit as its flagship quant fund — Alpha Global fund — lost close to 23 percent in the first few days of August 2007.

Despite its mantra of "making money regardless of market conditions," the quant community showed its vulnerability against sudden and irrational market changes during the summer of 2007. As the credit market began crashing all around the financial services industry, some of the highly leveraged hedge funds, unable to unwind their positions in the credit market, began dumping their holdings in liquid stocks to reduce their exposure. This triggered a short span of time in which markets began behaving completely at odds with what many quants' computer models had predicted. As a result, even those quant funds with no exposure to the credit market felt their own positions come under attack and began selling positions in liquid stocks to contain their losses.

The horrendous performance during August of 2007 led to another round of questions regarding whether or not quant funds -- which have been built around an aura of invincibility -- could really outperform the market regardless of prevailing market conditions. Emphasizing their complex computer models and commitment of zero "emotion" in investment decisions, quant funds had been touted as the investment model of the future.

Quantitative analysis was designed to achieve alpha like nothing before it. However, while the strategy largely has succeeded in its goal of achieving alpha, it does have certain drawbacks.