Quant shock that ‘never could happen’ hits Wall Street models

In retrospect, the manager at Great Lakes Advisors wonders whether he should have seen it coming

Jon Quigley says he probably should have known something big was coming -- even if his risk models didn’t.

Just a day after the Great Lakes Advisors manager watched CBS’s “60 Minutes” about America’s unprecedented efforts to deploy a vaccine when it comes, Pfizer Inc. revealed significant progress on its pandemic cure.

That revelation spurred the biggest moves ever in Quigley’s $3.9 billion portfolio. While stock benchmarks cheered the news, Wall Street’s most popular styles of quant trading got hit by a historic storm.

“Events happened that statistically never could happen,” said the chief investment officer of disciplined equities in a telephone interview from St. Petersburg, Florida.

The crash in the momentum factor was one that could statistically only happen roughly “once every 5,944,505,312,905,660,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 days in a normally-distributed return series,” he wrote in a client note.

As money managers rushed to price in stronger economic growth, factor investors who dissect stocks by how much they’ve risen or fallen saw this strategy, known as momentum, crash on Monday like never before. Equities more sensitive to the economic cycle like value and small-cap names skyrocketed.

So while the S&P 500 is just shy of its record high, it’s been a wild week for quants even by the standards of this wild year, with many enduring violent moves rather than capitalizing on the risk-on mood.

All this recalls long-standing worries that freakish cross-asset gyrations are getting more common thanks to cheap money and investor crowding.

Quigley’s estimate for the odds of this week’s shock is in part tongue-in-cheek, based on a rule of thumb for a normal distribution of statistical data. Asset moves are not known to reliably obey this convention that says 98% of all data points occur within three standard deviations of the mean.

But even with the knowledge that market prices are more prone to outlier moves, a rotation of the magnitude seen this week was still a shock to risk models.

Quigley’s small- and mid-cap strategy posted an eight-standard deviation drawdown compared with its forecast tracking error, he wrote in a letter to clients. Its large-cap portfolio, a three-standard deviation one.

This is a problem because quants decide how much market exposure to take by using historic data to calculate the odds of a fund’s positions imploding. If the distribution of price moves has changed from the past, history may no longer be a reliable guide to the present.

A rotation isn’t always a bad thing for active managers, but this week’s was so extreme that few investors were positioned for it. As a result hedge funds’ alpha, or excess returns, fell the most since March on Monday, and systematic funds suffered even more, Goldman Sachs’s prime brokerage data show.

By Wednesday momentum was rebounding, jumping the most since June to underscore just how volatile factors have become. Meanwhile, post-election relief may be helping the Cboe Volatility Index retreat, but that doesn’t mean it’s all smooth sailing for the benchmark.

Monday’s vaccine-powered rally meant the S&P 500 broke out of the trading range expected by the options market for the third week in a row. Since options are used to anticipate and protect from moves, that’s another sign of just how big the shocks have been.

Freakish swings of late have been blamed on cheap money, fast-money herding and thin liquidity. In August, Societe Generale quants used two decades of data to show that stocks and junk bonds have become more prone to fast gains and losses than ever before. Or in technical terms, the tails of a distribution of price data are getting fatter.

Quants are no strangers to the suggestion many of their strategies are built on historical data that might not repeat. But the idea is that, over a long enough time horizon, certain rules hold true -- and only looking at the recent past gives a limited view of asset behavior.

All the same, investors who tie their allocations to risk models look unlikely to put more money to work while these wild factor gyrations are ongoing.

In a Capital Market Risk Advisors survey on lessons from 2020, risk managers concluded that they need to conduct more stress tests that aren’t simply based on historical scenarios -- and should sometimes use their “gut feelings” when it comes to a shock as unquantifiable as Covid-19.

“It’s not a coincidence we’re seeing more 6 sig+ moves relative to history,” Cem Karsan, founder of Aegea Capital Management LLC, tweeted, using the symbol denoting standard deviation. “These aren’t your father’s equity markets.”