Internet stocks, the Nifty Fifty, Crocs—Wall Street’s littered with examples of what can go wrong when market fads run amok.
Is the same fate awaiting the increasingly popular investment style known as smart beta?
Among securities industry professionals, the threat level is rising. Concern stems from a surge in money chasing strategies that slice and dice the market based on various stock traits, such as factors like cheapness or volatility. Assets in these smart-beta exchange-traded funds, which use methods that are similar to actively managed portfolios but are in a passive instrument, just topped $500 billion for the first time.
And that’s just the tip of the iceberg. Interest in quantitative investing is exploding as traditional managers like Paul Tudor Jones recruit market technologists in droves. Thousands of data scientists are entering investing contests as crowd-sourced funds like Quantopian promise to plow funds into computer programs. Hedge funds have as much as $300 billion in quant strategies, much of it incorporating factor logic.
Quant’s a craze. And it’s starting to evoke memories of trades that got too crowded in the past.
AQR Capital Management’s Cliff Asness, while not in the Cassandra camp, says it isn’t unusual for the volatility of trading methodologies to increase once they seep into the public consciousness. Crashes, to Asness a natural feature of the investing landscape, become a bigger risk.
“I won’t pretend I don’t wish we were the only ones who knew about these,” the 50-year-old founder of Greenwich, Connecticut-based AQR said.
Concerns about market risks arising from stocks lumped together by factors have been around for a while, topping out a year ago when industry pioneer Rob Arnott warned that many strategies had worked because their popularity was puffing up valuations.
While far from unanimously accepted, Arnott’s theory reflected a concern common in trading circles that once a strategy becomes known, its charms diminish. For program traders, the classic example was the August 2007 quant meltdown, in which correlated bets among a swath of hedge funds turned sour and resulted in widespread losses.
Evidence has accrued over the years that it becomes harder to profit from market anomalies once they’re harvested en masse. Take investment ideas outlined in academic papers. Three years after publication, their returns fall by more than half, according to research from David McLean, a finance professor at DePaul University.