Opinion and Investing Column

Skarbeck: Trendy 'quant' hedge funds have run their course

February 22, 2014

Ken SkarbeckFor those who feel they missed capitalizing on the bull market in stocks, consider that an elite fraternity of heralded money managers actually lost money for their clients over the past three years. The Standard & Poor’s 500 index has produced a three-year cumulative return of 53 percent, yet hedge funds called commodity trading advisers, or CTAs, have lost a cumulative 7.4 percent.

These funds fall into the category of quantitative hedge funds, because their investment selections are driven by computer models using complex mathematical algorithms. The investment managers are typically mathematics Ph.D.s, and earned their degrees from such storied institutions as Massachusetts Institute of Technology and the University of Chicago.

It is estimated that $224 billion is invested in these quant-driven funds. Hedge funds managed by well-known investor Paul Tudor Jones and London-based Man Group Plc fall into this category.

Computer code seeks to exploit historical market trends and momentum strategies in stocks, bonds, commodities and currencies. Their proprietary models form “Black Box” trading platforms that are closely guarded secrets. In 2010, a former Goldman Sachs trader was convicted and sentenced to eight years in prison for stealing a computer code used in high-frequency trading of commodities and equities.

There are signs pension funds that entrusted billions to these funds are losing some confidence in CTAs, as $1.7 billion was withdrawn last year from these funds.

The public spiel by the consulting firms that advised pensions to pour billions into these funds claim they are not supposed to perform like conventional assets like stocks and bonds. After all, this slice of an institution’s portfolio is called “alternative.”

They advocate that it is good for a portfolio to have investments that are non-correlated, that in other words perform differently from each other, because it lowers the risk of the overall portfolio.

For their part, the quant managers argue that their models have not performed well due to market disruptions caused by the Fed’s quantitative easing activities. They claim the movement of security prices is distorted, upending their models.

More likely, the number of quant models out there trading securities and the amount of money invested in these funds has diluted their ability to outperform. Institutions also fell into their classic pattern of piling into CTAs after a streak of high returns.

Before the credit crisis, CTAs had logged outsized performance. In 2010, I attended a conference where consultants made elaborate presentations on investing CTAs and their institutional clients displayed outsized portfolio allocations to these funds.

Pensions can’t afford to have large allocations to investments that lose money for extended periods. They must meet their assumed rates of return to meet their long-term obligations to pensioners. Otherwise, they risk falling into underfunded status, which will require larger contributions by taxpayers or corporations.

Institutional investors started investing in complex investment strategies about 15 years ago, on the heels of the Yale University endowment’s success. Perhaps now a more conventional investment style is the path to higher returns.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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