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Quant strategies helped "intensify" financial crisis

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  • Quant strategies helped "intensify" financial crisis

UK/GLOBAL - Quantitative strategies are "partly guilty" of market distortion as "sudden de-levering" helped intensify equity market corrections, Barclays Capital has revealed. 

The firm's Equity Gilt Study 2008, which included research on resource scarcity, barriers to portfolio diversification and UK and US asset returns, also analysed whether particular hedge fund styles, such as quantitative strategies, are more vulnerable to crisis or more likely to create market distortion.

Sree Kochugovindan, from Barclays Capital, pointed out despite increasingly volatile financial markets, hedge fund performance produced double-digit returns across all sub sectors; the first time in 10 years returns have been uniformly positive. 

Although the research confirmed the worst performers in 2007 were the more systematic and quantitative styles, such as fixed income arbitrage and managed futures, Kochugovindan claimed historically there was "little evidence" to suggest quant funds were more vulnerable than other styles, and argued there was "no clear evidence to suggest quantitative strategies should be avoided during times of turmoil".

But her research confirmed quant funds, rather than hedge funds, may be "partly guilty of market distortion" and of triggering the second leg of the equity market correction in August.

Kochgovindan pointed out the credit market seizure fuelled the first stage of the equity market correction in July, but admitted a "domino effect' was created in August when a few large funds unwound positions triggering "sell signals" across a range of similar quant models.

The report added: "Although quant strategies may not initiate the correction, sudden de-levering by these funds seems to intensify the financial crisis."

In addition, the research included findings from Barclays Global Investors (BGI) about four "demons of illusion" which limit both the potential for returns and the risk control benefits of diversification.

Lindsay Tomlinson, vice-chairman of BGI Europe, warned in pension funds portfolio managers have tended to concentrate on the "riskiness" of the assets rather than the liabilities, and further argued in UK pension funding there appears to have been a "mismatch" of assets and liabilities as since January 2002 the FTSE All-Share has started to improved in value, yet the liabilities of pension schemes have increased just as fast. 

He claimed by ignoring the liabilities managers are ignoring the most volatile part of the portfolio, and to combat this suggested pension funds should be "explicitly hedging liabilities" and possibly incorporating them into the benchmark or at least to start thinking of liabilities as part of a core neutral portfolio when they are dealing with asset allocation.

In addition, BGI highlighted three other "demons":

too much focus on capital allocation rather than risk allocation, which can impact diversification benefits; too much focus on asset class rather than "underlying systematic risks", such as interest rates and economic growth, and the need to understand the difference between implicit and explicit leverage.

Research claimed the investment community has become scared of heavily or explicitly-leveraged investments, such as hedge funds, yet it invests in securities which have embedded, or implicit, leverage without noticing, as it revealed in 2007 the S&P 500 carried $0.88 (€0.60) of debt for every dollar of equity.

Additional figures from the research relating to the 2007 asset returns in the UK and US revealed cash was the best performing UK asset with a return of 1.8% after inflation, while equities achieved just 1% compared to 1.2% for gilts. 

Findings revealed equity and corporate bond performance was damaged by the credit squeeze, as corporate bonds returned -6%, while government bonds were weakened by rising monetary policy in the second half of the year.

If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email nyree.stewart@ipe.com

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