Sometimes machines are only as smart—or dumb—as the humans who program them.
Hedge fund investors learned that the hard way last year when data-crunching computers that invest $220 billion based on historical price trends did worse than most other managers, robot or human. The losses were so bad that investors pulled billions of dollars out of an investment strategy that for years had, paradoxically, been regarded as a great way to protect portfolios from downside risks.
Turns out the algorithms behind so-called trend-following quants are rather primitive and suffer from many of the same weaknesses a mortal brain might. They've struggled to react fast enough to the unforeseen side effects of ending a decade of central bank stimulus, and even seem to get baffled by U.S. President Donald Trump.
“The models can’t move as fast as the tweets,” said Brooks Ritchey, senior managing director at Franklin Templeton’s K2 Advisors unit who oversees $3.6 billion and has exited all but one of the trend-following quants it used to invest in.
A lot has changed since systematic trend-following quants, known in the industry as Commodity Trading Advisors or CTAs, won a big following after gliding through the 2008 global financial crisis.
Around them, the community of quantitative investors—computers designed and encoded to identify trades and execute them—expanded exponentially and their algorithms grew more sophisticated.
“It’s a strategy which in its pure terms is really probably obsolete”
Robotic traders now manage about $1 out of every $3 held in the world’s $3 trillion hedge fund industry, including models that use inputs like company’s profitability, trends in volatility or shifts in economic cycles to make trading decisions. Many are handing investors big returns and are lauded for preventing human emotion from clouding trading judgment.
But trend followers keep it simple, identifying when to enter and exit trades by back testing price trends against decades of data. When the algorithm determines it’s probable for a market to rise, automatic buy orders are placed for futures or derivatives contracts in anything from stocks and bonds to commodities and currency forwards. Alternatively, if the price forecast looks bleak, positions are taken in short futures, betting assets will fall.
Problem is, they aren’t very good at responding to surprises—and there have been plenty when central banks removing support from markets can trigger abrupt spikes in volatility or a 280-character tweet from Donald Trump can exacerbate tensions with China. Ultimately, the speed of markets these days can easily confound the historical price trends at the heart of the approach.