Thursday, June 16, 2011

Regarding The Recent Equity Market Turmoil

There's little doubt that the mechanics and dynamics of the US equity markets changed as of late April and early May. The latter timeframe saw volatility begin to rise, while the S&P peaked on May 2nd, falling nearly 9% since then.

At times like these, I consider how different equity portfolio management styles react and perform under such conditions.

As I've written in prior posts, the framework and structure of a quantitative approach to equity portfolio management gives me confidence in relying on my tools, signals and consistent management methods. I can't fathom how a qualitative manager responds to such rises in volatility and a plunging index.

For example, my signaling tools for long/short allocation are still, despite the recent market decline, displaying values associated with long positions. Thus far, June's S&P total return is nearly -7%. A few more months like this and the signal will turn to short allocations. But it's quite likely that the next few months will see the indicator remain long. It's September and after that appears to be the worrisome period. However, while I simulate its behavior, I don't forecast the indicator- I use its contemporaneous output. That's one of the benefits of having time-tested, non-forecasted, quantitative components of a quantitative equity management system.

Thus, I was mildly surprised by the reaction I recently received from someone presented to me as a formerly-successful hedge fund manager. This recent post concerning a networking situation gone wrong due to a friend's inept and lying contact. The same contact made much of connecting me with the alleged hedge fund manager whom I'll call L.

The initial feedback was that L was seriously interested in learning more about my portfolio management approach and performance. But after a few days had passed, I grew sceptical. I requested L's email and sent him my one-page description, along with an invitation to discuss my approach at our mutual convenience. Several days passed with no reply. Not knowing L, nor having spoken with him, and seeing his non-response as possibly a change of mind, or, more likely, wrong information in the first place regarding his interest level, I forwarded my initial email with another suggestion that we talk or meet. Later that holiday weekend, L sent me a reply which read, in part,

"I personally have no need for a black box. I had a partner that left me 20 years ago to work on his algorithmic program. I am aware of all the success stories and I'm sure your is as prudent as the rest. I've seen some very sophisticated programs but in the end nothing that has held up to the tests."

I had to laugh when I read L's response, as it contained such a mix of naivete, bad thinking and errors of logic.

First, why would someone being approached to invest in or back an equity management process believe he will remain 'in the dark' regarding said process? While I've never relinquished control or shared possession of my software code, I've explained how my quantitative process works in detail to former partners. Only an idiot would believe that the process would remain a 'black box' to him.

By the way, even a fundamentals-based analytical type of manager who pores over 10Ks is a quantitative manager. Quantitative means numeric, and probably algorithmic, but not necessarily advanced physics or calculus.

Second, it seems that a long-ago slight by L's former partner has left him biased against all quantitative equity management processes.

Finally, the assertion that "nothing...has held up to the tests" suggests some pretty faulty logic circuits in L's brain. For example, just that week, one of the world's larger hedge funds announced that it was creating a new quantitatively-managed fund.

Several of the best-known and -performing hedge funds, including Jim Simons' Renaissance, are quantitative. So I guess they have passed "the tests."

Precisely which "tests" L is referring to is a mystery to me, and I've been involved in equity management since 1997.

Then, again, considering the wild goose chase on which I was led with the contact's first allegedly valuable network connection, I have my doubts that L had, in fact, developed, built and sold a successful equity management business. Or that he even has substantial funds to invest in one now, either.

There are varying preferences for returns, consistency, etc., over varying periods of time by individual investors or backers of hedge funds and equity management ventures. But, to my knowledge, there is no single set of "tests."

What I wondered, in contrast, was, if L doesn't like quantitative, disciplined, rigorous approaches to equity management which at least have the advantage of being able to be backtested, what does he prefer- totally subjective managers with no ability to retroactively model their selections and performance? If he's worried about "black boxes," does it get any blacker and more impenetrable than an individual manager's undocumented mental meanderings?

Equity markets like those of the past few months and, probably, the next several, always lead me to wonder why anyone would risk their investments on pure, inexplicable subjective hunches without any sort of objective guidelines or rules.

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