At the CFA Institute: Of quants and how much money managers are paid

Nassim Nicholas Taleb, author of “The Black Swan” and a harsh critic of quant strategies, told the CFA Institute’s annual conference in Vancouver, British Columbia, not to confuse volatility with risk. A black swan is a highly improbable event that is unpredictable, has a massive impact and that people try to describe in hindsight to make it seem less random and more predictable, according to Mr. Taleb’s best-selling book.

For example, Mr. Taleb noted in his speech that Italy has had more than 60 governments since World War II, making the country more volatile, but Saudi Arabia — ruled by the same family for more than 130 years — is a far riskier regime.

He also warned of growing systemic risks in the world financial system. The shrinking number of banks seems to limit the number of blowups and makes the financial system appear more stable. The problem is that when a blowup occurs, it has bigger ramifications than in the past, he said.

“The probability of an event happening drops but the consequence is higher,” he said.

Mr. Taleb also had harsh words for other conventional quant wisdom. The Law of Large Numbers — which says that one or two large events won’t throw off averages — doesn’t apply in all situations. For example, five drugs out of 267,000 on the market account for the vast majority of profits, he said. The same is true for best-selling books, where five account for about half of all book sales, he said.

Recognizing the preponderance of portfolio managers and analysts in his audience, Mr. Taleb was apologetic in his criticism of quants. After all, he was one himself before he joined academia. Still, he warned the conference of the dangers of attending conference sessions. “If there’s an equation, close your eyes,” he said, evoking laughter from the audience.

A study commissioned by the CFA Institute’s Research Foundation found that quantitatively managed equity returns are suffering due to rising correlations, style rotation and use of the same data and similar models.

“We essentially have 10,000 Ph.D.s looking at the same data,” Vadim Zlotnikov, CIO for growth equities at AllianceBernstein LP, New York, told the conference.

In the study, most quant managers blamed their problems of last summer on the unwinding of long-short positions by hedge funds. The similarity of quants’ investment processes was the second most-important factor in their performance problems, managers said.

As a result, managers are trying to add new factors and turn to other data sources to differentiate their approaches. Quants also think existing risk management tools are inadequate in predicting severe events. The managers surveyed remain somewhat optimistic that they will continue to build up market share at the expense of fundamental managers. Investment consultants, however, are more negative, given quant managers’ rough patch of performance.

The research found that quant managers face significant hurdles in their quest to generate stable alphas: overcrowding by quant managers, limited capacity, the need to find new and unique factors and models, and the ability to handle rotation and regime shifts.

Some quant managers are seeking to add qualitative judgments to their investment processes, creating a hybrid model. But most quant managers and consultants are more comfortable with sticking with purely quantitative approaches, according to a CFA Institute news release announcing the study.

In his talk, Mr. Zlotnikov discussed how portfolio managers at his company are working to integrate fundamental and quant approaches.

It’s very hard work, he said. For example, timing regime shifts between value and growth stocks is tough. There have been only five shifts over the past 20 years, providing precious little data from which to draw conclusions, he said. He said managers will look to contextual and non-linear application of signals to enhance future performance.

The research, which was unveiled on Monday, was based on interviews with managers, consultants and others, as well as a survey of 31 U.S. and European asset managers with a total of $2.2 trillion in equities under management.

In his kickoff address, Steven Levitt, author of “Freakonomics,” entertained the conference with tales from his book and his experience giving economic advice from a Chicago call girl. He later invited the call girl, a former computer programmer, to talk to his University of Chicago class on crime and economic – a lecture some of his students said was the best they heard in their four years at the university.

Mr. Levitt, who is an economics professor at the University of Chicago, adroitly handled questions from the audience. But one query caught him off-guard. Asked why investors pay so much to money managers who don’t meet their investment targets, Mr. Levitt hemmed and hawed at first. But then he found his response. He questioned how long hedge fund managers would be able “to get away with charging 2 and 20” fees.

“That to me is the puzzle of all puzzles,” he said to scattered applause.

Contact Joel Chernoff at [email protected]