Inside the Black Box: The Simple Truth About Quantitative Trading

11.3. QUANTS CANNOT HANDLE UNUSUAL EVENTS OR RAPID CHANGES IN MARKET CONDITIONS

This is perhaps the most valid criticism of quant trading so far. Quants must rely on historical data to make predictions about the future. As a result of this dependency, it is likely that quants will suffer any time there is a significant and sudden change in the way markets behave. It bears repeating and emphasizing that, in order for the event to be of importance to a quant, the regime change must be both large and without much warning. Perhaps the most challenging time for quant trading in its known history has been the period from late July 2007 through August 2008. Over this roughly 13-month window, quants faced the liquidity crisis and at least three separate episodes of substantial pain. You can see this illustrated in part in Exhibit 11.1.

As you can see from this figure, Value outperformed Growth from mid-2004 through early 2007. There was a reversal of this trend beginning in mid-May 2007, which accelerated aggressively in late July 2007 and was a likely cause of the poor performance among quants that contributed to their liquidation. The trend favoring growth over value from May 2007 to January 2008 is easily seen to be sharper than that which favored value before May 2007. Many quant strategies had adapted to this new regime by the middle of the fall of 2007, leading to strong performance in the later part of that year. But two other periods catch the eye: one in January 2008, and the ...