Cruising Across Our Speculative Markets

Quants have it tough.  Few in the investment world really understand what you do, and even fewer outside that world.  To many investment managers, quants are the guys nipping at their heels, clipping their returns, and questioning the need for fundamental analysis.  There comes a kind of schadenfreude when their models blow up, where qualitative mangers get to say, “See, I knew it was too good to be true,” and in the newspapers, a kind of bewilderment at eggheads whose models failed them.

I write this as a hybrid.  I am a qualitative investor that uses quantitative models to aid my processes.  As such, I was hurt, but not badly, but recent market troubles.  Any class of models can be overused, and the factors common to most quant models indeed became overused recently.  Truth is, the models don’t vary that much from quant shop to quant shop, because the market anomalies are well known.  Many of these funds held the same stocks, as seen in hindsight.  Should it surprise us that their results were correlated?

In a situation like this, success tends to breed more success, for a time, as more money gets applied to these strategies.  The statisticians should noticed the positive autocorrelation in excess returns, rather than randomness, which should have tipped them off to to much money entering the trade.  But no.  There was another calculation that could have been done as well, estimating the prospective return from new trades, which was declining as the trades got more popular.  My view is that a quant should estimate the riskiness of his strategy, and compare the returns to those available on junk bonds.  When the return is less than that available from a single-B bond, it’s time to start collapsing the trade.  (What, they won’t pay you to hold cash?  No wonder….)

On a different topic, consider mark-to-model.  I’ve said it before, but Accrued Interest said it better when it said that mark-to-model is unavoidable.  Most bonds in the market do not have a bid at any given time.  Most bonds are bought and held; beyond that, there are multiple bonds for a given company, versus one class of common stock.  The common stock will be liquid, and the bonds merely fungible.  It is even more true for structured securities, where the classes under AAA are very thin.  The AAAs may trade, classes with lower credit ratings rarely do.

Now the same argument is true when looking at a whole investment bank.  How do you mark positions that never trade, and here there is no readily indentifiable bid or ask?  You use a model that is built from things that do trade.  Sad thing is, there isn’t just one model, and there isn’t just one set of assumptions.  It is likely that the investment banks of our world, together with those they deal with, have marked illiquid securities to their own advantage.  Assets marked high, liabilities low.  Aggregate it across all parties, and the whole is worth more than the parts, due to mismarking.

Now for a tour of unrelated items:

  1. There is something about a spike in volume that reveals weaknesses in back offices.  For derivative trading, where there is still a lot of paper changing hands, that is no surprise.
  2. Prime brokerage is an interesting concept.  They bring a wide variety of services to hedge funds, but also compete in a number of ways.  At my last firm, I never felt that we got much out of our prime brokerage relationships for what we paid.  They provided liquidity at times, but not often enough.  Executions were poor as well.
  3. The market sneezes, and we worry about jobs on Wall Street.  Par for the course.  What is unusual here is that few bodies were cut 2001-2003, so pruning may be overdue.  It may be worse because the structured product markets are under stress.
  4. Catastrophe bonds are opaque to most, and Michael Lewis did us a favor by writing this.  That said, though this article begins by suggesting that 2007 will be an above average hurricane season, I ask, “What if it is not?”  It is rare for the hurricane season to shift halfway through the season.  It may be time to buy RNR, FSR, MRH and IPCR.  But regarding cat bonds, they are issued by knowledgeable insurers.  After issue, there are dedicated hedge funds that trade them, taking advantage of less knowledgeable holder, who only originally showed up for the extra yield.
  5. A break in the market affects obscure asset classes as well.  If wealthy hedge fund managers are the marginal buyers of art, and they are getting pinched now, the art market should follow.
  6. Message to Mish: If Bill Gross is shilling for a PIMCO bailout, we are all in trouble.  If the prime mortgage market and the agencies are in trouble, then I can’t think of anyone in the US that will not feel the pain.  I think Bill Gross is speaking his mind here, much as I think that Fed funds rate cuts are not needed, though I also think that they will happen, and soon.
  7. Many emerging debt markets are in better shape than the US, because their current accounts are in better order.  Now, as for this article, Brazil might be okay, but Turkey is not in a stable place here because of their current account deficits, and I would be careful.
  8. Finally we are getting real volatility.  I like that.  It helps keep us honest, and shakes out weak holders and shorts.

See you tomorrow, DV.

Tickers mentioned: IPCR, MRH, FSR, RNR