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.
[…] all sorts of biases. They perform better when they are locked into some process (see here, here, here and here for the wordier […]
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What does daily rebalancing mean? That the components of the 30 changed on a daily basis? Or that winners were sold and losers were bot on a daily basis?
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The latter. Stocks no longer meeting the criteria are sold and stocks meeting the criteria are bought on a daily basis.
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I am curious as to what the parameters are as well.
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What the heck are the parameters for that spectacular 47% CAGR Russell 3000 system??
Doubt I’ll get an answer – but does it have any momentum or mean reversion element with the stock prices – or is it just pure fundamental value? It must have a price behavior element or wouldn’t be neccessary to rebalance daily.
I also appreciate the comment by A Shelat.
Also, any thoughts on the best brokerage to use considering fills and commissions on fairly active but small trades – say 300 trades/year of $3000 each??
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[…] Every trading system undergoes drawdowns. What matters is how to you react to them. (Abnormal Returns also Greenbackd) […]
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Great post. Perhaps the substance of the post argues for some degree of value averaging. What do you think about using an indicator like the Shiller 10-yr smoothed P/E as an admittedly rough means to justify initiating a equity strategy?
To A Shelat’s point, I don’t think it is an accident that when Buffett set up his original partnership his asset allocation was roughly 1/3 to general undervalued equities, 1/3 to workouts, and 1/3 to arbitrage.
Eric
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I appreciate the post. I was having just such a “Fear” moment a week or two ago.
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It seems like (1) strategy diversification, in addition to asset diversification, and (2) a limit on leverage would greatly help alleviate the probability of a temporary failure in one strategy. While I am drawn to deep-value, Graham-style investing principles, I employ several different strategies to mitigate the possible failure of a single one. After all, there are many paths to nirvana when it comes to investing.
For example, one could choose along the following lines:
(a) time horizon: from high-frequency to long-term
(b) factors: macro, bottom-up fundamental factors, technical factors, etc.
(c) methodology: theory-led quantitative, statistical-led quantitative, Graham fundamental value, Piotroski fundamental valuation, merger arbitrage, etc.
(d) leverage: zero leverage for long-term, low-liquidity, low-Sharpe strategies to high leverage for extremely short-term, high-liquidity, high-Sharpe strategies
(e) asset classes
I’ve personally found that using several strategies and having radically different sources of alpha help to depress the volatility of my returns and provide a mental cushion to continue forward with well-tested strategies and ideas, even though their time may not be in vogue.
As always, a great post and I really enjoy your blog. Cheers…
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These are great suggestions.
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I thought that was a sensational post. Thank you.
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