In A Crisis In Quant Confidence*, Abnormal Returns has a superb post on Scott Patterson’s recounting in his book The Quants of the reactions of several quantitative fund managers to the massive reversal in 2007:
In 2007 everything seemed to go wrong for these quants, who up until this point in time, had been coining profits.
This inevitably led to some introspection on the part of these investors as they saw their funds take massive performance hits. Nearly all were forced to reduce their positions and risks in light of this massive drawdown. In short, these investors were looking at their models seeing where they went wrong. Patterson writes:
Throttled quants everywhere were suddenly engaged in a prolonged bout of soul-searching, questioning whether all their brilliant strategies were an illusion, pure luck that happened to work during a period of dramatic growth, economic prosperity, and excessive leverage that lifted everyone’s boat.
Here Patterson puts his finger on the question that vexes anyone who has ever invested, made money for a time and then given some back: Does my strategy actually work or have I been lucky? It’s what I like to call The Fear, and there’s really no simple salve for it.
The complicating factor in the application of any investing strategy, and the basis for The Fear, is that even exceptionally well-performed strategies will both underperform the market and have negative periods that can extend for three, five or, on rare occasions, more years. Take, for example, the following back-test of a simple value strategy over the period 2002 to the present. The portfolio consisted of thirty stocks drawn from the Russell 3000 rebalanced daily and allowing 0.5% for slippage:
(Click to enlarge)
The simple value strategy returns a comically huge 2,450% over the 8 1/4 years, leaving the Russell 3000 Index in its wake (the Russell 3000 is up 9% for the entire period). 2,450% over the 8 1/4 years is an average annual compound return of 47%. That annual compound return figure is, however, misleading. It’s not a smooth upward ride at a 47% rate from 100 to 2,550. There are periods of huge returns, and, as the next chart shows, periods of substantial losses:
(Click to enlarge)
From January 2007 to December 2008, the simple value strategy lost 20% of its value, and was down 40% at its nadir. Taken from 2006, the strategy is square. That’s three years with no returns to show for it. It’s hard to believe that the two charts show the same strategy. If your investment experience starts in a down period like this, I’d suggest that you’re unlikely to use that strategy ever again. If you’re a professional investor and your fund launches into one of these periods, you’re driving trucks. Conversely, if you started in 2002 or 2009, your returns were excellent, and you’re genius. Neither conclusion is a fair one.
Abnormal Returns says of the correct conclusion to draw from performance:
An unexpectedly large drawdown may mark the failure of the model or may simply be the result of bad luck. The fact is that the decision will only be validated in hindsight. In either case it represents a chink in the armor of the human-free investment process. Ultimately every portfolio is run by a (fallible) human, whether they choose to admit it or not.
In this respect quantitative investing is not unlike discretionary investing. At some point every investor will face the choice of continuing to use their method despite losses or choosing to modify or replace the current methodology. So while quantitative investing may automate much of the investment process it still requires human input. In the end every quant model has a human with their hand on the power plug ready to pull it if things go badly wrong.
At an abstract, intellectual level, an adherence to a philosophy like value – with its focus on logic, discipline and character – alleviates some of the pain. Value answers the first part of the question above, “Does my strategy actually work?” Yes, I believe value works. The various academic studies that I’m so fond of quoting (for example, Value vs Glamour: A Global Phenomenon and Contrarian Investment, Extrapolation and Risk) confirm for me that value is a real phenomenon. I acknowledge, however, that that view is grounded in faith. We can call it logic and back-test it to an atomic level over an eon, but, ultimately, we have to accept that we’re value investors for reasons peculiar to our personalities, and not because we’re men and women of reason and rationality. It’s some comfort to know that greater minds have used the philosophy and profited. In my experience, however, abstract intellectualism doesn’t keep The Fear at bay at 3.00am. Neither does it answer the second part of the question, “Am I a value investor, or have I just been lucky?”
As an aside, whenever I see back-test results like the ones above (or like those in the Net current asset value and net net working capital back-test refined posts) I am reminded of Marcus Brutus’s oft-quoted line to Cassius in Shakespeare’s Julius Caesar:
There is a tide in the affairs of men,
Which, taken at the flood, leads on to fortune;
Omitted, all the voyage of their life
Is bound in shallows and in miseries.
As the first chart above shows, in 2002 or 2009, the simple value strategy was in flood, and lead on to fortune. Without those two periods, however, the strategy seems “bound in shallows and in miseries.” Brutus’s line seems apt, and it is, but not for the obvious reason. In the scene in Julius Caesar from which Brutus’s line is drawn, Brutus tries to persuade Cassius that they must act because the tide is at the flood (“On such a full sea are we now afloat; And we must take the current when it serves, Or lose our ventures.”). What goes unsaid, and what Brutus and Cassius discover soon enough, is that a sin of commission is deadlier than a sin of omission. The failure to take the tide at the flood leads to a life “bound in shallows and in miseries,” but taking the tide at the flood sometimes leads to death on a battlefield. It’s a stirring call to arms, and that’s why it’s quoted so often, but it’s worth remembering that Brutus and Cassius don’t see the play out.
* Yes, the link is to classic.abnormalreturns. I like my Abnormal Returns like I like my Coke.