The Failure of Quant Funds

Last Updated Sep 7, 2010 9:27 AM EDT

I have to thank my good friend Taylor Larimore of the Bogleheads Investment Forum for making me aware of this story.

In 2006, Registered Rep ran an article discussing how quant funds (funds managed by computer models) were all the rage. According to the article:
  • Eighty one quant funds were introduced in 2006, up from only three in 2001.
  • Assets held in quant funds tracked by Lipper approached $40 billion, up from $19 billion at the end of 2002.
  • In five years up to the article's publication, quant funds had returned an average of 6.95 percent per year, while all actively managed U.S. stock funds averaged a return of 5.93 percent per year.
Fast forward four years. Morningstar's Fund Spy ran the story "When Quant Funds Failed." The article detailed some of the carnage wrought on quant funds:
  • Bridgeway had seven of its eight quant funds in the bottom third of their Morningstar categories for the three years through July 28, 2010. Six of Goldman Sachs' eight quant funds with three-year records were in the same boat.
  • JP Morgan's eight Intrepid brand quant funds each lagged its typical category peer over the past three years.
  • AXA Rosenberg's four Laudus funds will soon be liquidated.
In aggregate, quant funds have failed to deliver on their promise. The group of 65 quant funds examined by Morningstar trailed three-fourths of their peers over three years ending July 28. And that's exactly what we should expect. Even successful active management contains the seeds of its own destruction. Economics professors Dwight Lee and James Verbrugge explain the power of the Efficient Markets Hypothesis as follows:

"The efficient market theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns. [For example] If stock prices are found to follow predictable seasonal patterns unrelated to financially relevant considerations, this knowledge will elicit responses that have the effect of eliminating the very patterns they were designed to exploit. The implication here is rather striking. The more empirical flaws that are discovered in the efficient market theory, the more robust the theory becomes. [In effect] Those who do the most to ensure that the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it."

Note the similarities between the following from the Morningstar article and Lee and Verbrugge's explanation:
  • Robert Jones, a senior advisor for Goldman Sachs Asset Management's large quant team, told the Journal of Portfolio Management that both "value and momentum signals have been losing their effectiveness as more quant investors managing more assets have entered the fray."
  • Sandip Bhagat, Vanguard's head of equities, "thinks quant managers need more secondary factors to give them the upper hand, but he also wonders how many new factors exist. 'There are so many smart people sorting through the same data.'"
  • Ted Aronson, founder of quant firm Aronson+Johnson+Ortiz, said: "We're not all going to go out and stumble on some new source of alpha."
The historical evidence suggests that relying on active managers -- whether they be fundamentalists, technicians or quants -- is highly likely to prove to be an unproductive strategy.

More on MoneyWatch:
Will Commodities Wreck Your Portfolio? Factors to Consider for High-Dividend Stock Strategies A Simple Way to Beat the Market Do Waddell & Reed's Ivy Funds Add Value? Can Investing Be Too Simple?
  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

Comments

Market Data

Watch CBSN Live

Watch CBS News anytime, anywhere with the new 24/7 digital news network. Stream CBSN live or on demand for FREE on your TV, computer, tablet, or smartphone.

Market News

Stock Watchlist