Old Mutual Global Investors' Leif Cussen asks whether a quant crisis could reoccur in today's smart beta products and what can be done to protect against it.
Why is crowding a concern? As these strategies become more popular among UK pension schemes, there is concern that a sudden mass exodus could cause sharp drawdowns as demand for liquidity spikes.
In August 2007, significant drawdowns, particularly focused on systematic equity value, accompanied both forced and discretionary selling.
Although the sharp falls had largely reversed by the end of the month, many funds, having de-levered, missed out on this bounce back. The investor disenchantment that followed cast a long shadow over much of the quant investment space for years afterwards.
Crowding can be very difficult to define, let alone detect
Some feel that a recurrence of 2007’s event is not likely today as lessons have been learnt. Indeed, a wider range of systematic strategies, or factors, are now utilised and there is a perception that there is less use of leverage.
But while there has been much exciting innovation over the past 10 years, we should not forget that a significant proportion of quant strategies still use fairly classic factors such as systematic value, low volatility and size.
Indeed, the rise of cheaper generic quant funds has been partly driven by the commoditisation of these more vanilla approaches.
And while it is true that long-only smart beta strategies do not typically use leverage, there have also been substantial flows into long/short or market-neutral strategies that are typically levered.
Crowding tricky to measure
The quant crisis occurred in a world where managers were attempting to demonstrate the difference between their implementations and the rest of the market.
Now, with the increased popularity of more generic factors, there is arguably even less difference between some implementations than there was in 2007. Against this backdrop, the risk of crowded exits in the systematic space is one that still exists and should be addressed.
One solution often suggested is that, by monitoring levels of 'crowdedness', fund managers can dial down exposure as a factor becomes more crowded.
However, crowding can be very difficult to define, let alone detect. Certainly, by many measures, systematic equity value did not look crowded prior to August 2007.
Even if you can detect crowding, how do you use that information? Many factors actually exhibit some of their best performance as they are becoming more crowded.
Multi-factor could hold key
Another potential solution, diversification, can go a long way. Many simulated systematic strategy backtests do not show a drawdown during the quant crisis.
This is often because they include factors that were not negatively impacted by the crowded exit of 2007. This could be because they are genuine diversifiers, but we should also be careful not to fall into a trap here.
If these new additions had also been components of the typical quant portfolios of 2007, would they have also been caught up in the deleveraging? If so, they might not provide the diversification they appear to have done in retrospect.
We should take extra care with the more widely used generic factors, although this is clearly less of a risk with genuinely proprietary strategies.
Quant has its place in portfolios
As a quant manager, I believe in the ability of well constructed market-neutral systematic strategies to enhance risk-adjusted returns through their low correlation to equity and bond markets.
It has been a good decade for many diversified portfolios of systematic factors but it is important not to ignore the potential for a crowding event to deliver drawdowns not anticipated by historical backtesting.
Systematic strategies are now widely used by pension schemes. The democratisation of quantitative investing brings with it both challenges and opportunities and it is important for fund managers to educate investors, set realistic expectations of both risk and return, and explain how they seek to mitigate the potential risks of a quant crisis rerun.
Leif Cussen is lead portfolio manager of the Old Mutual Style Premia Absolute Return Fund at Old Mutual Global Investors
