Last week's issue of The Economist magazine carried an intriguing article about the fading fortunes of a certain type of hedge fund. Since 2009, 'quant', or trend following funds, have suffered a severe reversal of fortunes. These hedge funds used to make decent returns till 2007. Even in 2008, when the global markets crashed, they did well. The distinctive thing about these funds is that they employ automated, rules-based trading that is guided by pre-decided algorithms. While the algorithms are programmes created manually, the actual trading is without any manual interventions.
So why have these funds stopped doing well since 2009? According to data quoted in the magazine, in the five years to 2008, trend-following funds generated returns ranging from 7 to 18 per cent. Such returns are very high because we are talking of investments in Europe and the US, where inflation is miniscule and risk-free returns like bank deposits have negligible returns. Incidentally, the 18 per cent returns were for 2008, when all other types of investments did very badly indeed. In India, the Sensex was down 52.45 per cent during that year. However, the years that followed have been bad for these funds. Clearly, the computer algorithms have stopped working, and the models that were so good at predicting trends till 2008 are in trouble now. The question is, why has this happened? The Economist discusses an interesting theory, that the flaw lies not with the quant funds or with their algorithms but with the markets! On the face of it, this sounds like a joke.
After all, the world is full of cranks who believe that their theories are correct but the world makes a mistake when it doesn't behave according to them. But the idea does have some merit. The basic problem is that since 2008, markets have been moving less according to market forces and more according to the actions (and inactions) of governments and monetary authorities.
The idea is that it matters little if the trend following funds can identify the trends that the markets are showing. Take the latest example, which is the Federal Reserve's announcement of its 'tapering' and then its postponement. Around the world, all markets, not just equities but also bonds, currencies and commodities, have spent a few months driven back and forth by nothing but tapering. Equity analysts understand little of the ebb and flow of American politics but have been busy guessing whether Barack Obama will make Larry Summers the next Fed chief or whether he will choose Janet Yellen. The worst part is that this has damaged the basis of diversification.
And it's not just the US. Even more so in India, it's now all about politics and government. It matters little whether you choose the safest blue chip or the most speculative small-cap adventurer. Which government comes to power matters more in how much money investors will make.
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