Equities keep hitting record highs and volatility hovers near historic lows, all while geopolitical tensions abound. As a surreal bull market staggers onward, Bloomberg Markets asked around for reasons to worry.
Quant Quake 2.0
When you look back at the financial crisis, the quants stand out as the canary in the coal mine. Model-driven funds experienced massive losses in August 2007—a full year before the rest of the financial system came to its knees. The event, dubbed the Quant Quake, may have resulted from one large liquidation: Leveraged quant funds pursuing similar bets then unwound at an unprecedented clip. AQR Capital Management, a $208 billion quantitative money manager, was among them, and the experience left some lingering bruises—and worries about the future.
To AQR’s founder, Clifford Asness, Quant Quake 2.0 is inevitable. Quant strategies are popular, and popularity is what makes a coordinated action, whether it’s a run on the bank or a crash, possible.
“In the early ’90s, when I first started doing these strategies, they were relatively unknown. There was a low chance of a significant amount of dollars fleeing at once,” he says. “What we don’t have now is a monopoly that protects you from common actions.”
Asness is far from a neutral observer. Investors in quant land have been particularly keen on the strategy behind AQR’s success that he pioneered: factor investing, which groups stocks based on market-beating characteristics such as volatility or value. That success, he concedes, heightens the likelihood of a historically large crash, an “event with a big left tail.” But that isn’t enough to deter Asness from factor investing.
“We have a whole body of literature by smart people confirming what we think, another 25-or-so years of out-of-sample evidence that our strategies work and, despite all of this, reasonable pricing of these strategies,” he says.
The financial system also looks healthier than it was during the Quant Quake: less leverage, reasonable valuations, more conservative implementations. According to Asness, future crashes will be short-lived, a survivable “fact of life going forward and a consequence of being in good, well-tested strategies that other people know about.”
Even so, there’s one scenario that concerns him, because of the ubiquitous media spotlight on the markets: a vicious feedback loop of selling fueled by negative coverage. “Crashes have a little bit of psychological magic to them. August of ’07 went by relatively unnoticed. I don’t think that will be the case this time,” Asness says. “In this case, the revolution will be televised. What kind of feedback loop that creates is a wild card I worry about.”
Still, like most investors humbled by their experiences in 2007, the legendary quant isn’t ruling out any possibility for when Quant Quake 2.0 rolls around. “I expect an event to be not as bad. Or maybe as bad because we missed something. We’re honest nihilists about it,” he says. “With all that said, we’re still guessing. These are wild events.” — Dani Burger
The Wild Card
Bill McNabb took over Vanguard Group Inc. just as the financial crisis hit. He’s since helped the buy-side behemoth add more than $3 trillion to its assets under management. As he prepares to leave the post of chief executive officer at the end of 2017, he says his biggest worry isn’t a big correction so much as “some sort of cyber event.”