Investment

Family offices should reallocate funds to private assets to avoid continual booms and slumps

According to Goodhart’s Law: “When a measure becomes a target, it ceases to be a good measure.”

But that’s never stopped quant managers trying to create funds using mathematical measures which can outperform for years, but cease to do so when their funds target too much money.

ETFs now manage $8 trillion. They cover every conceivable asset, sector and geography.  You can find proxies for hundreds of asset classes such as junk bonds, gold, short positions, oil, wheat and bitcoin.

Nor has it stopped the quants producing funds that use leverage to manage volatility and produce a steady return but end up distorting the market.

The machines haven’t exactly taken over, as yet, but their influence has produced unprecedented volatility such as this year’s sudden 25% collapse in speculative growth stocks.

The wisdom of crowds appears to be getting weaker, as the quants move in. Family offices could be forgiven for turning their backs on the market to avoid the geeks and invest in private assets.

Leon Cooperman once remarked that the quants have turned the market into a “wild, wild west environment”. Which is a bit rich coming from a hedgie, but you get the point. 

Cooperman has retired from the fray and converted his Omega Advisors hedge fund into a family office like many of his peers.

How did all this begin? It was forty years ago in 1983, when Fred Grauer took charge of Barclays Global Investors, at roughly the same time as James Simons began Renaissance Technologies, which used computers to manage risk arbitrage with spectacular success.

Grauer became more influential than Simons because BGI won so much institutional and retail business.

His mastery of technology, and its potential, entranced his fans, who called him  “the godfather of quant management.” 

In 2009 when Barclays sold BGI to BlackRock for $13.5 billion, many analysts reckoned it should have sold the bank instead.  Grauer came as part of the deal, and advised BlackRock until 2015.

He is believed to be involved with a family office called Grauer Brothers Capital. His personal interests have centred on philanthropy and venture capital for some time. 

He backed Google and PayPal in their early years. He is a senior adviser to Credit Sesame, which helps consumers manage cash and credit on a single site for nothing.

At the start, BGI used data and analytics to develop passive funds whose stock weightings were continually adjusted to stay in line with the index. 

Its strategies beat active managers most years due to their hefty fees. Median returns from active managers reflected their reluctance to take risks with client money. Active managers are quite bad at selling stocks, according to data provider Inalytics. In rising markets, they take profits too early. 

BGI’s marketers made hay. The big irony is that share prices reflect the collective wisdom of active managers, as they buy and sell stocks. This wisdom of crowds leads to regular changes in stock market indices, giving passive managers a free ride.

BGI, and its rivals, went on to turn their passive strategies into ETFs which also lead to a lower tax charge for clients than mutual funds.

ETFs now manage $8 trillion. They cover every conceivable asset, sector and geography.  You can find proxies for hundreds of asset classes such as junk bonds, gold, short positions, oil, wheat and bitcoin.

ETFs even claim to save the planet. Funds flowing into ESG strategies tripled to $89 billion in 2020. Momentum is continuing. Rather than carrying out their own research, green investors are happy to leave the job of screening stocks to their manager. Such touching faith. 

Quant funds also comprise style factors, like growth and value. Managers have measured and marketed 400 of them, using measures of prior outperformance which complied with Goodhart.

They were called smart beta, until their measures ran into trouble during the growth surge, producing far less impressive underperformance. 

Investors have been passing the parcel rather than investing in stocks.  As money cascades into different index buckets the price of shares rises, forcing other indexed funds to buy them all the way up. Rising prices in a given sector leads to the creation of more ETFs, pushing prices higher still.

Leveraged quant managers with a brief to manage volatility through risk parity and other approaches aim to trade their way out of trouble at the first sign of danger. This is challenging when you dump stock in a market starved of liquidity, as we saw in 2008. 

Computer-driven trend followers reinforce these trends because they have to base their positions on prior data.  And markets are driven by high-frequency traders rather than reassuringly sceptical market makers who now only account for 10% of US equity trading. 

Algorithms are programmed to swerve away from danger, leading to problems when they move at the same time.

Until this year, quants were aligned with the tech-driven growth story, lapping up debt at near-zero interest rates.

As is often the way, retail investors added to a late burst of momentum, along with active managers reluctant to move too far out of line.   

Tesla shot up because it was, well, Tesla. Shares in fuel cell minnow Plug Power surged 11-fold because it backed a hot sector. Its value hit $30 billion.

When retail investors “loaded up” on GameStop, they wanted to bear down on hedge funds shorts. They never checked its fundamentals because they assumed markets would keep rising. 

What happens next? Disruption is still happening and will not go away; US stimulus is set to enter the market; money coming out of bonds needs to go somewhere; inflation is still reasonably contained

Large-cap growth and tech achieved massive overweight positions, as the gap between growth and value stocks hit an all-time record. Value has never suffered such a large discount to growth.

This year, the quants started getting worried because of the fall in US Treasury bonds and fears that central bank stimulus will hike inflation. This meant speculative growth stocks (and SPACs) could struggle to hit their long-term earnings expectations.

It didn’t take too much quant modelling to decide that value stocks offered a safe harbour due to their shorter-term appeal of their cash flow and dividends. The rotation to value became virtually immediate.

The Russell 1000 value index has risen by 10% this year, while its growth equivalent has fared no worse than marking time. The Fang+ is only up 3% after losing most of its gains earlier this year.

What happens next? Disruption is still happening and will not go away; US stimulus is set to enter the market; money coming out of bonds needs to go somewhere; inflation is still reasonably contained.

Some say the time has come to return to fundamental analysis and stock picking and they may be right. 

But maybe it is also time for family offices to reallocate funds to private assets to avoid continual booms and slumps. 

The quants aren’t going away any time soon and when we get quantum computers in twenty years, the Game really will Stop.

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