| Perfect storm pummels quant strategies |
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| 02/09/2007 | |
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It was not only in Paris and London that weather conditions were poor in August. A perfect storm punished most quantitative strategies which experienced a jump in factor correlation. Fortunately, for quantitative investors, the weather forecast for factor de-correlation is likely to improve as it usually does following periods of forced de-leveraging. Value, quality, momentum and earnings revisions strategies were down more than 100bps within a few trading days into mid-August. (The 100bps represents the spread between returns of a basket of top performing stocks and a group of bottom-performing ones. In this case, the basket of top performing stocks underperformed the bottom-performing ones in each of the four quantitative strategies.) At the same time, 20-day pair-wise correlations between the four quantitative factors moved up to 60% on August 15 (the highest level of the month) compared to a long-term average of 10%, says Adam Strudwick, quantitative analyst at Citigroup. These quantitative strategies, which are typically market-neutral, underperformed during the month as previously uncorrelated factors fell at the same pace. What made these factors act more like each other was forced selling and de-leveraging. "We searched through history trying to find events when factor correlations were increasing and when the five-day rolling returns for all four factors (value, quality, momentum and earnings revisions) were negative," according to the Citigroup report. "We found that all four factors tend to recover in the next 20 days and correlations revert back to more normal levels." Indeed, Strudwick expects the correlation in factors to drop, though they are likely to remain higher than they have been historically. "A dramatic increase in correlations among what were perceived to be orthogonal (different) factors is the big challenge for quant portfolios." Although correlations have not been extraordinarily high given historical standards, this was a perfect storm, concludes the report. Citigroup looked for similar events in history when the five-day rolling returns for all four strategies were negative and the average pair-wise correlation among them was more than one standard deviation higher than the three-year average. Out of 3,264 daily observations since 1995, it found 538 events (16%) when correlations moved more than one standard deviation above the three-year average. The scenario when all four factors underperform and correlations rise is even rarer. "There have only been 69 such events in history (2.1%)," according to Citigroup. "Our results show that the underperformance and volatility of quant factors does not represent an extreme event. We have plenty of examples in history when that has happened; what is really rare is the increase in factor correlation and the simultaneous underperformance in a number of quant strategies." VB |
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