Once More Unto the Breach?

This month is the ten-year anniversary of the "quant crisis" or "quant quake" - that one week period in August 2007 when quantitative equity strategies like factor investing and statistical arbitrage suffered very large losses and then, in the next few weeks, made an almost full recovery. Given the current popularity of factor investing it seems a good time to review what happened that summer and discuss its relevance for today.

Following closely on the heels of the event, in September 2007, I did a write-up of what we thought happened. It took the form of an interview about the crisis with myself where I, with a lot of help from others at AQR, wrote the questions and the answers (I think you may catch me telling myself "that's a very good question"). Re-reading it today I think it holds up pretty well, though maybe it sounds a bit dated in places. So, I won't spend much time here reviewing the actual crisis other than to note that it was a true liquidity crisis, a trading "unwind." It was not some fundamental change. This is likely why it recovered so quickly (liquidity events are often highly temporal while "real" events are usually more lasting). Of course, "highly temporal" events can kill, so that isn't a dismissal, just a definition.

Let's agree that all-else-equal it would be nice to eliminate all strategies with big "left-tails" (i.e., strategies that can suffer statistically shocking down days or weeks.) We would all sleep better. But, all-else-is-not-always-equal. Some of those left-tailed strategies are pretty good. The obvious example is just getting long the stock market and earning the equity risk premium. It has a serious short-term left-tail 1  (e.g., October 1987 and August 1998) but also has been a great long-term strategy. To achieve those long-term returns you do have to survive those left‑tail events (survival as in staying solvent and invested but also not voluntarily throwing in the towel at the exact wrong time). 2

To start, we need to separate the ongoing debate about factor valuations from the question of short-term crash risk. In general, and not just for factors, valuations and short-term crash risk have a tenuous relationship at best. 3  Valuations have some predictive power for long horizon factor returns, more so for slower turnover factors (like the market itself and, to a lesser extent, the value factor) than for faster ones. 4  But small sample sizes can make long-horizon inferences difficult to make with confidence. Separately, we have also shown that factor valuation today is not very extreme. 5  This makes the question of whether valuation-based predictability "works" a pretty theoretical one right now. But, quite separate from valuation and the long-term outlook, because factor investing is so popular today, and the underlying strategies so well-known (at least in their basic forms), I've said as part of this, this, this, and this, that factor investing is now more vulnerable to short-term extreme turbulence (a polite euphemism for a few days of getting its butt absolutely kicked).

This is the crux. Short-term extreme movements are a function of lots of people trying to do the same thing at the same time. 6 7  Of course many trying to do the same thing at the same time could itself be triggered by over-valuation. But, again, that link seems historically tenuous at best as value holds sway at the long- not short-term. 8 Further, as we discussed back in September of 2007, factor valuations were not extreme going into that August cyclone, and thus weren't the trigger then either. Irrespective of the specific trigger, it's hard to imagine coordinated mass selling of a factor strategy occurring without it being well-known and widely implemented. That seems almost definitional. 9 And, the factors were popular back in '07, similar to today. 10

So the next question is what can trigger sharp selling of a popular well-known strategy even if it's not very over-priced? Well, lots of things. I won't pretend that predicting such conflagrations is even vaguely a science, and I'd note that we didn't predict the August of 2007 quake nor did anyone else, as far as I know. 11  But we can identify a few of those things that can start the fire. For example, it could be something like a banking crisis, an abrupt regulatory change, or a loss of ability to maintain short positions. It could be triggered by poor performance if it's severe and abrupt enough to cause people to drastically reduce their desire to take risk in those strategies. It could particularly happen if there are large and sudden redemptions facilitated by investment terms linked to poor short term performance (for example, a structured product or fund with features that require immediate redemptions based on recent poor performance - we do think this combination contributed to the '07 crash). With all that said, we're still guessing. These are, by definition, rare and wild events. One of the only things we can be fairly certain about is that the next crisis won't be a repeat of the last but they probably will rhyme.

In discussing what might cause sharp selling of factor strategies, it is useful to discuss upfront some of the different ways quantitative factor investing is implemented. Many factor portfolios are still essentially traditional, long-only and implemented without leverage, designed to beat a benchmark by overweighting the stocks preferred by the factor or factors in question. The most famous version here is often called "smart beta" though we've argued before that is mainly a relabeling of something that's been around a great while. At the other end of the spectrum are factor portfolios held in long-short form, possibly long and short similar amounts (i.e., trying to be market-neutral). Removing market exposure from a factor reduces the risk per dollar of exposure and reduces the correlation of that factor with other factors in a portfolio, leading to significantly lower risk per dollar of exposure for the multi-factor portfolio. 12  The resulting benefit is a better risk adjusted return but at the cost of being too low risk per dollar to matter much. Leverage can, and often is, used to make such a market-neutral factor portfolio matter in the investor's overall portfolio. Thus, leverage is quite useful, but it also can be a new danger.

While we don't think anyone can reliably forecast specific events, we are more confident about what conditions make these liquidations more likely and, if they do occur, more severe. These speculations ultimately come down to who is betting on the factors and how (in what structures and with what rules - one example discussed above being structured products with specific forced redemption rules). For instance, it seems obvious that the higher the fraction of factor investors that use leverage, and the more leverage they use, the bigger the chance of another August 2007. In an unleveraged investment there are two people who can panic sell at the wrong time, the asset manager and the client. In a leveraged investment there is often a third interested party - the lender (who can often bring great pressure to bear.) On this front we take some comfort in noting that in 2017 versus 2007 it appears that far more of the factor world 13  pursues these strategies without leverage (e.g., we think "smart beta" is the biggest area of growth and that is just very simple long-only, unlevered factor-based investing). 14  It also seems clear that those using leverage (including AQR in strategies where we use leverage 15 ) are far more conservative (conservative = less leverage) than in 2007. 16 17  All-in-all this is not an "all clear" by any means. But the factor investing world, at least in terms of the fraction of assets using leverage and, we'd guess more importantly, the actual amount of leverage employed where it's used at all, is more conservative than in 2007. 18 19 20 21

An unheralded fact of the quant crisis of '07 was that from peak to trough of the factor drawdown, the S&P 500 was flat to up a bit. 22 23  That is, even while losing big, quant factors were market-neutral during the quake. The overall market's lack of interest or reaction to the quant crisis in 2007 is important. It would be an interesting contest, and perhaps a future blog topic, to come up with the single biggest common investment error out there. 24  But one candidate would surely be over-worrying about parts of your portfolio and not focusing on the whole. Granted sticking with a levered market-neutral quantitative factor investment process would be quite difficult through the '07 quake if that was 100% of your portfolio. But difficult at a 20% allocation? At 10%? At 5%? Sizing exposures such that you can stick with your investments through their worst times is a big part of long-term success. Conversely, sizing your investments such that you're near guaranteed to abandon them during really tough times is a recipe for near certain failure. I would wager that had they kept an overall portfolio perspective, few quant investors (outside of the all-quant firms themselves) were suffering enough to have had to take action at even the depths of 2007. But many might have panicked by viewing just their quant/factor sleeve in isolation - perhaps a lesson for next time (if there is a next time!). 25

Another related difference between today and 2007, this one making now a scarier time, is that the financial media coverage and interest in factor investing is much higher than in 2007. That's pretty much a tautology with "more popular and more widely known." Again, August of 2007 went by relatively unnoticed outside of the quant world. I don't think that would be the case this time, even if markets as a whole are unaffected. In this case, the revolution will be televised. What kind of feedback loop that creates is a wild card I do worry about as, anecdotally, people seem to act less rationally the more headlines a topic garners. 26

So, where does that leave us, the community of factor investors? I like to compare today to nearly thirty years ago when I first was introduced to and started studying value and momentum strategies. Well, since then, we have near thirty years of  out-of-sample evidence that they work. 27 28  This includes testing them in a whole lot of other places (geographies and asset classes) and times. We've added a few more good factors to the mix, but by no means have we populated a "zoo." 29  And today, we even can invest in these factors at historically fairly normal pricing, for the most part. 30  What we definitely do not have is an informational monopoly on them that protects us from the actions of other competing, or fleeing, capital. Unlike thirty years ago it's more likely that our short-term returns can be buffeted by the actions of other factor investors. 31  This prospect is not just theoretical as we saw it happen, big time, ten years ago. To state the remarkably obvious, something that has happened before can happen again. In fact, I'd say it is likely to happen again at some time (hopefully, long after I'm gone). 32  This is far from unique to factor investing - there isn't a widely known liquid investment strategy that isn't subject to the left tail of other investors' short-term actions. 33  The stock market itself is, once again, the primary example of this fact.

So, what do we do with very good (imho!), but, as of today, widely-known strategies? We think, not shocking I know, you should still allocate to them but do so conscious of their known left tail. Investing while in denial of real possibilities is never a good strategy. But, you're not dissuaded from allocating to an S&P 500 index fund because a -10%, -20%, or worse day or week is possible, are you? 34  Rather, you do know that can happen and plan for it, right? 35  We think investors should collectively educate themselves about this possibility to minimize panic and maximize rationality should it happen. We think we should all structure our investments specifically thinking about these events, knowing this is part science and part art, to survive and even be able to take advantage of them. But, ultimately, if we believe these factors are real and priced reasonably (particularly in a world where many investments, like traditional stock and bond markets, are quite expensive), we should invest in them. We should just do it with open eyes and a plan.

Time for some final summary advice. 36  Long-term investors who are pursuing unlevered factor tilts versus indices (this includes "smart beta") should steel themselves to ignore some possible short-term periods of large relative return differences vs. their benchmarks. Long-term investors pursuing market-neutral leveraged strategies should similarly steel themselves, but in this case for absolute (not versus benchmark) suffering. These investors in particular should think hard about August of 2007 and future similar possibilities when designing their portfolios and deciding how much to allocate to them. Finally, short-term investors unprepared for any such turda nu bulence should eschew these factors and, instead, find a set of great strategies only they know about with thirty years of out-of-sample tests (and out-of-sample not just in time, but also in geography and asset class), with only a vanishingly small possibility of short-term crashes (as they are their secret), and yet are still reasonably priced today. Good luck with that!