The Contrarian

“In the investment markets, what everyone knows is usually not worth knowing.”
Market Crash

Could the DOW lose 4000 points in one day?

Here is an excellent article about the accelerating trend of having computers decide on trades rather than human beings. They call these the “Quants.” One hedge fund, Renaissance Technologies, has done very well with this. It was the early mover. But could there be an ominous outcome?

Now that everyone is starting to play the same game, the profits will get smaller and smaller, until there aren’t any left. In effect, everyone will be aiming at everyone else.

Here is an excerpt from “The Paradox of Quant” from The Reformed Broker by Joshua Brown:

The hot new thing among the gut-trading, gunslingers of yore is to bring in quants and PhDs and data scientists and algos to address the lack of alpha that’s been competed out of the hedge fund game.

Point72, formerly SAC, just announced a $250 million investment into Quantopian, a crowdsourced fund comprised of algorithms and data-mined strategies. Paul Tudor Jones, whose flagship fund has been alpha-challenged for almost a decade now, is calling in the Geek Squad to computerfy his firm’s trading situation.

“Jones, suffering losses and about $700 million in investor withdrawals in the second quarter, has accelerated a high-tech revamp at Tudor Investment Corp. in the past year, according to three people familiar with the matter. Scientists and mathematicians, some with doctorates, have joined Tudor to bring new analytical rigor to its trading strategies,” the people said. It may work.

But the Paradox of Quant is going to come into play eventually. The more firms (and dollars) there are seeking to emulate the success of Two Sigma and Renaissance Technologies, the less gains there will be to go around. There aren’t going to be ten or twenty RenTechs (although there could be, but all of them with lower returns).

Today’s arms race into quantitative and algorithmically driven strategies will be no different than all other Wall Street arms races of the past: The getting is good at first, until it works. Then it becomes a circular firing squad, as thousands of people and institutions pick each other’s profits off while engaging in similar strategies. This very thing is playing out in Smart Beta as we speak, with over $425 billion now allocated to factor-based ETFs, almost a third of the entire ETF market.

Once crowded, there are a few choices for practitioners of a given investing discipline:

  1. Pretend it’s not over
  2. Adapt and move on to the next thing
  3. LEVERAGE UP
  4. Sell out to a competitor

My friend and colleague Dan McConlogue tells a great story about The Merger Fund, an arbitrage mutual fund meant to profit from the distance between an acquirer’s offer and a target’s price in the narrow window of time between the announcement of a takeover and the closing of the deal. It was a great fund and the profits were both non-correlated and steady.

My view: Josh Brown is an experienced money manager. He correctly points out that when everyone uses the same strategy, profits become very small.

However, there is something more ominous in our opinion. The worst outcome will not be diminishing profits. That could be the best case scenario. A more ominous outcome is that if they all use a similar computer algorithm, it could someday lead to massive selling that feeds on itself.

On August 24 2015, the DJI lost 1089 points in less than 30 minutes. Most investors have already forgotten about that. Lots of ETF’s traded at values 30%-50% below the value of the fund’s stock holdings. The regulators never properly explained what happened. But it was obvious that the machines had taken over.

In 1986-1987, the Los Angeles based firm Leland O’Brien made an institutional strategy by hedging stock portfolios by short-selling index futures. They sold the concept to very large institutions, saying “you never have to sell a stock in a bear market.” The methodology was to sell an increasing number of index futures short as the stock market declined.

At the time, we wrote in our WELLINGTON LETTER that eventually this could cause an unstoppable crash. It was so easy to predict. The floor traders on the futures exchanges would just go to the sidelines when they saw the avalanche of sell orders in the index futures. And that is just what happened on October 19, 1987, also known as Black Monday. The DJI plunged over 22% by the close. Only the fact that the market closed stopped the decline.

Why wouldn’t this happen again? With computers that can enter 90,000 trades per second, you could easily see the DJI plunging 3000-4000 points in a day.

It’s a brave new world.

Wishing you successful investing,
Bert Dohmen

Read the full article here: http://thereformedbroker.com/2016/08/03/the-paradox-of-quant/