Human Traders Are Trouncing The Machines

The contemporary low volatility trading environment has been kind to actively managed equity funds - particularly if they piled into large-cap momentum stocks like Facebook and Amazon, which have been responsible for the bulk of this year’s rally.

But while active managers have enjoyed three quarters of strong returns, quant funds – purportedly the future of asset management, according to many an “expert” on Wall Street – are falling further and further behind. As Bloomberg reports, during the first nine months of 2017, the average equity fund was up 9.7 percent while quant funds rose only 0.6 percent, according to data from Hedge Fund Research.

The striking reversal has validated the views of the handful of quant-fund skeptics on Wall Street, many of whom were previously branded as “luddites” for questioning the inherent superiority of algorithm-driven investment strategies. Quant funds, as we are learning, don’t function well in a low volatility environment because there are fewer opportunities to exploit small disparities in price.

The environment that lifts stock pickers - steady markets that enable their long-term trades - is not so friendly to quants. They do best in periods of volatility and dispersion, when their algorithms can find small price disparities to exploit. But the U.S. stock market has been unusually tranquil since last year’s presidential race. At an average level of 11.6 since Election Day, the CBOE Volatility Index has hovered about 40 percent below its lifetime average.


“To a certain extent they are lowly correlated," Tim Ng, chief investment officer of Clearbrook Global Advisors, said of the two strategies. “The factors that drive positive returns in each are different, so what helps one doesn’t necessarily help another.” His firm invests in hedge funds.

Despite their recent underperformance, quant funds have continued to receive the bulk of hedge fund inflows. Last year, total hedge fund assets AUM dropped for the first time in years as investors pulled money from actively managed funds and reallocated to both passive and quantitative strategies.

Still, both quant funds and traditional discretionary managers have on average continued to underperform the S&P 500.

Equity funds betting on technology have posted some of the biggest gains in the first three quarters. Light Street Capital Management’s Halogen fund, which focuses on technology, media and telecommunications stocks, soared 44 percent, said a person familiar with the matter. The flagship fund at Philippe Laffont’s tech-focused Coatue Management jumped almost 24 percent, according to an investor letter seen by Bloomberg News.


Computer-driven funds struggled to keep pace in the period. BlueTrend, the main fund at Leda Braga’s Systematica Investments, dropped almost 7 percent, another person said. The Diversified fund at $6.6 billion Aspect Capital fell 4.7 percent, according to an investor letter seen by Bloomberg News. Winton Group’s Futures fund is about flat on the year, according to a person with knowledge of the returns.


While the hedge fund industry’s overall performance is improving, it still lags behind the S&P 500 Index, which was up 14.2 percent with reinvested dividends this year through September. Funds across all strategies on average returned 4.3 percent on an asset-weighted basis in the period, compared with 0.7 percent in the first nine months of last year, according to Hedge Fund Research.

As we noted above, funds focusing on tech stocks have posted some of this year's biggest gains:

Equity funds betting on technology have posted some of the biggest gains in the first three quarters. Light Street Capital Management’s Halogen fund, which focuses on technology, media and telecommunications stocks, soared 44 percent, said a person familiar with the matter. The flagship fund at Philippe Laffont’s tech-focused Coatue Management jumped almost 24 percent, according to an investor letter seen by Bloomberg News.

And to be sure, not all quant funds have had a bad year. Bloomberg managed to find one that’s up 53%.

Not all quants have had a bad year. The QIM Tactical Aggressive Fund gained 53 percent in the first nine months, according to a letter seen by Bloomberg. Nor have all traditional stock pickers done well. Crispin Odey, who is known for his bearish bets, saw his European equity fund sink 14 percent this year through Sept. 15 in its U.S. dollar share class.

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After Eagle’s View Asset Management, a $500 million fund-of-funds that invests with 30 managers, half of them quants, recorded its worst monthly performance ever in June, the fund’s manager Neal Berger penned a letter to clients explaining why quant strategies have broken down over the past year.

It comes down to two factors, he said:

1.Increased competition: more investors are using algorithms to fight over the same inefficiencies in the market.

“Now every bank has a factor model,” said Benjamin Dunn, president of the portfolio consulting practice at Alpha Theory LLC, which works with managers overseeing about $200 billion.


“You’ve had a democratization of a lot of data and analytics that were once the domain of very systematic quant investors. Everything is getting arbitraged away.”

2. Low volatility: quantitative funds are most successful in an environment where there is large disagreements in the market over the prices of assets. Today there is little disagreement, and the best way to earn outsized returns is placed highly leveraged bets that the market will remain calm. That's working for some investors, but is far too risky for others.

In fact, the persistently low level of volatility has brought out an increasing number of hedge funds strategies oriented toward regularly selling volatility. Although we believe that this is "picking up nickels in front of a bulldozer", shockingly, these Funds have been some of the best performing strategies over the past years.


Although our guess is as good as anyone's, we believe the shockingly low levels of volatility has to do with an increase in computer driven, quantitative trading coupled with banks selling options to offer "yield enhancement" structured products to investors who are starving for this yield.


This feedback loop, the increase in assets run by hedge funds, and, the rise of quants, has created unusual patterns, dislocations, and low levels of volatility.


While those simply following the broader market indices wouldn't realize anything is amiss, it is our belief that these factors have created a challenging mix for trading oriented strategies. It won't last forever, but, it could last longer than we can.

Additionally, he explains, systematic strategies require an endless supply of victims to thrive, and the growth of quant and passive funds has caused dumb money to behave unpredictably or disappear altogether.

With all the geniuses in quant, high-powered computers, and enormous data, where are the "suckers" who are providing the juice for all of these absolute return quantitative strategies?


Simply put, the 'edge providers' have moved aggressively into passive index funds and broader market ETFs.


As such, we have a condition amongst the traditional quantitative strategies whereby we have robots trading against robots. Without a steady source of 'edge providers', these 'edge demanders' are just trading money back and forth with each other.


We believe increased quantitative trading coupled with passive indexation by retail, and, low levels of realized and implied volatility may be creating a feedback loop that has caused unusual price movements in a variety of securities that have challenged trading oriented strategies.

Of course, all of this could change shortly as market strategists like Bank of America’s Michael Hartnett warn that a sharp selloff could be in store for the fourth quarter. Investors have upped their bullish bets through S&P 500 calls, buying more S&P 500 delta over the past two weeks than at any point since 2007.

In summarizing the contemporary market, Hartnett explains that the "best reason to be bearish in Q4 is there is no reason to be bearish.”

Complacent active managers ought to keep this in mind.


YUNOSELL Irvingm Tue, 10/10/2017 - 09:01 Permalink

I can't really understand what is so difficult about BTFD -- computers can obviously do this faster than human tradersOnly thing that will throw this winning strategy off is when the FED truly ends the artificial stimulus, and we all know that will only be when the invisible threshold is breached and people lose trust and the final snowflake lands on the snow pile and the avalanache commences and the system morphs

In reply to by Irvingm

burocracy Tue, 10/10/2017 - 04:46 Permalink

My partner is an international chess master, and he related to me the story of the game between Garry Kasparov and IBM's "Deep Blue" computer. first game, Kasparov inputs move and Deep Blue inputs moves, Kasparov wins. hands down.At this point, the rules are slightly altered. No longer are the moves coming directly from deep blue, IBM hires two east european grand masters, who receive the Deep Blue move, vet it, and then THEY move. After that, it's a new ball game.

seabass974 Tue, 10/10/2017 - 04:46 Permalink

The machine algos don't understand irrational greed, market manipulation and corruption .. this is far easier for human traders to understand and get their snouts in the trough before in implodes.

adamas Tue, 10/10/2017 - 04:57 Permalink

I have personally developed a robot for trading. It increased an initial £6000 into £450,000 in a 12 month period for a friend , without dropping below zero. I thought trading long gold and short dollar vs yen was a good strategy after the Donald was elected. It took about a week to nearly bankrupt me  The dollar went from 101 yen to 118 without a relief rally....  I'm working on a gentler version now :-)

Golden Showers Tue, 10/10/2017 - 06:48 Permalink

Real John Henry shit.I've always wondered this: Do human beings make machines with our intelligence to make us more intelligent?Can that be done?Kind of like asking if God created mankind in his image to make God more intelligent.Did God make more money creating us and the world?Why do we humans create machines if they are not a tool?Human beings are motivated by greed, lust, cheating, murder, power, and multiplication of force. Or resisting the same from other humans. When you put it in perspective, human beings selectively develop tools that secure their continual reproductive success at the very least. Human beings do not create. Human beings synthesize information and develop strategies that enable avarice and protection.Human beings and thier tools, their fire, their technology, are fascinating. When you can employ a machine that is faster and programmed to return gain for you, someone without that technology is paying you. And when there is a person who beats that machine it is time to build a new machine, write a new program.We are not creative beings any more. We have become recursive. It's the nano pico cent pile raided a billion times over. As we descend into shorter lengths of time for smaller units of mesh size we are heading toward a constant.Oh, but at the same time we have developed weapons that more and more efficiently destroy more and more people. And when we people are destroyed who is left?Min Max the destruction, the theft, and you are left with a constant at infinity in algebraic terms. An asymptote. A limit.So I do not think that people create. People learn. People count cards, hack computers, cheat, steal, rape, murder, and are proud.But when you print money and then make machines and program them for gain, machines that are faster and approaching limits, then you control two variables. And when you also make equalizers, efficient weapons capable of destroying life itself for eons, control government and media and lie about it, the people who are smart and break your machines are your new recruits. It's recursive.And although we peaceful, God fearing, caring, empathetic truth seekers already have a machine called a Republic with a bitching program called a Constitution and Bill of Rights, we think it isn't fast. Oh, it's fast. But it's exactly why people went through the trouble to pry it from our cold dead hands and build the world you see around you. And so, we become machines for our betters who now program us and we imagine somehow becoming free one day in the future while the most disgusting murderous filth has it's day, it is with our consent and our pleasure to be so free to be manipulated all the live long day.

Calculus99 Tue, 10/10/2017 - 07:02 Permalink

Think back to the old pits. Can't have everyone making big money as the money paid to the best has to come from somewhere. So there will be a pyramid in operation. 2-3 top traders, 10-20 good ones, 100 so-so and a lot picking up scraps (via cheating probably). No different from the Algos. You cannot have all of them making top money. The trouble with the Algos versus a human trader is the investment. A human can set himself up with almost no cost but it needs MILLIONS to setup a proper Algo operation. Plus, a constant stream of further investment to keep ahead of the crowd. Algos are sexy, I'll give you that.