

Shrinking ‘Quant’ Funds Struggle to Revive Boom - nsoonhui
http://www.nytimes.com/2010/08/20/business/20quant.html?ref=business

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BenoitEssiambre
There is kind of an odd tone to this article as if the shrinking of the quant
economy is a tragedy when in fact it should be the natural course of this
sector if it is not too corrupted. The efficient market hypothesis and
information theory tells us that using probabilistic models to extract a
competitive advantage can only give good returns when your method is better
than all of your competitors'. When two firms have similarly optimized
tactics, they bet against each other and the margin of money than can be
skimmed off their betting market will shrink to almost nothing. I don't mean
that the profits will be split between the two. I mean the bidding war will
push the price towards its optimal value where no money can be extracted.

In a competitive quant market, as all the firms perfect their mathematical
models, they should all move asymptotically towards the best probabilistic
model possible given the available information and eventually erase each
other's gains.

The boom in computing technology of the past thirty years was an immense
opportunity for mathematicians to make money by racing to perfect their models
before others. However, as this industry matures it should eventually take
only a few very good systems to extract a thin margin that will barely cover
the cost of running the systems themselves.

Moving towards that point of efficiency is a capitalist and libertarian
victory that people (at least those who believe in capitalism) should
celebrate. The conclusion is a market so efficient that little money can be
extracted by betting in it. That means money going to the real economy instead
of the wall street casino and more value for everyone. The fact that the
sector is shrinking indicates the free market is actually working.

I don't believe in the free market everywhere but I think when it actually
works well and create value we should be glad, not lament the loss of the
casino profits.

This allegory illustrates the efficient market hypothesis nicely:
<http://agoraphilia.blogspot.com/2005/03/doing-lines.html>

~~~
secretasiandan
1) There will always be non-professionals/non-quantitative people making
trades that create potential profit for those who wish to arb them.

2) You can still make "good" returns even when you have the worst of the
models because of 1).

3) It takes more than N>>2 firms to shrink the profit in a particular model to
0. For evidence, see the large number of high frequency funds that make great
returns.

4) The market/world is always changing so the 'best' probabilistic model is
always changing. As long as the professionals are moving faster than the non-
professionals, they can still extract money.

Could you define what you mean by the real economy? Isn't the real economy
whatever it is that solves other people's problems that they will pay you for?
The fact that "the sector is shrinking" doesn't mean that its not going to
grow still larger long term. I would say that we're just on the back side of a
bubble. There are many many many people out there who call themselves quants
that shouldn't.

You're waxing philosophic about a hyper efficient future but I don't think it
matters because that future won't be here for a very long time.

See 1), 4) and the second to last setence of your allegory (Information only
makes a difference if the number of people who have it is small.) for why
professionals/someone will always be able to make good returns.

~~~
BenoitEssiambre
You make some valid points but don't forget that even the non professionals
making mistakes will get less losses and a return closer to a long term index
when better quant system are betting agains each other and keeping prices
close to their optimum levels.

It is not certain at all that the worst professional models will make money
just because there are non professionals that are even worst. If the better
models are aggressive enough, they should be able to take most of what there
is to take from the non professionals and also profit from betting against the
lesser professional models (to a lesser extent).

I still maintain that as the models get better and better while they bet
against each other, the margin for profit is reduced and the sector as a whole
should shrink and that's a victory for capitalism.

~~~
secretasiandan
"don't forget that even the non professionals making mistakes will get less
losses and a return closer to a long term index when better quant system are
betting agains each other and keeping prices close to their optimum levels."

Do you have an argument/explanation for this? Also, why are the quant systems
necessarily betting against each other?

"It is not certain at all that the worst professional models will make money
just because there are non professionals that are even worst."

I didn't mean to imply that its a certainty, only that its a possibility. I
mean our whole argument is about some possible utopian future, right?

"I still maintain that as the models get better and better while they bet
against each other, the margin for profit is reduced and the sector as a whole
should shrink and that's a victory for capitalism."

Aren't you just saying capitalism works? Can't I say the same thing about all
those darn internet startups extracting value from me because they're
providing me information? Would you use the same argument to conclude that the
space of internet startups will shrink?

~~~
yummyfajitas
In a completely efficient market, any stock is just as good as any other - you
make or lose money solely due to chance. Nonprofessionals will only take
trading losses if they are unlucky .

(Of course, a non-professional who wishes to treat eTrade as a casino may lose
money on transaction costs.)

You absolutely can say the same thing about internet startups extracting value
by providing you information - but you are incorrect to conclude that the
_space_ of internet startups will shrink. In fact, what will shrink is _profit
margins_ \- as more startups are created, all the easy alpha is off the table.
Witness what is happening to newspapers right now.

~~~
secretasiandan
re completely efficient markets, you're right. My eyes focused on the "making
mistakes" part and missed the "closer to" part. I guess I could throw
something in there about gambler's ruin, but that would be a little pedantic.

re the space of internet startups : To be clear, I wasn't concluding one way
or the other, just asking him to apply the same logic to something he might
have positive bias towards and see if he comes to the same conclusions. Also,
rather than number of companies, I think the market cap/total profit of the
companies is a better metric.

I'm not sure that company margins in internet startups or quant finance will
shrink. I haven't thought too much about it but I think they might even grow
as information/efficiency attains greater value. Margins per action done might
shrink but number of actions will grow. Isn't this the whole story of HFT?

Further, old lines of business will have their margins shrink as the service
becomes commoditized. But new high(er) margin lines of business will spring up
in their place.

~~~
yummyfajitas
In the case of HFT the number of actions has grown only because there was
alpha sitting on the table, but it wasn't worthwhile for human market makers
to chase it.

Think about a strategy which generates $100/day trading OTSS (Obscure Thinly
Traded Symbol), a security with a $0.25 bid/ask spread. No human will waste
their time on this strategy, so $100/day of alpha is left sitting on the
table. HFT allows a computer to chase after this $100, $50 on some other
stock, etc. This is simply a case of 3 programmers + computers doing work
which was unprofitable for humans to do.

Similarly, twitter didn't exist before the internet because no human would be
willing to earn $0.0003/day hand-delivering short messages to anyone who cared
to listen, being paid to verify that "yes, this message really came from
Mallika Sherawat".

Once the market becomes saturated, the bid/ask on OTSS will shrink to $0.10
and the algorithm will only generate $40/day. We are already approaching that
point in HFT.

As for margins, they may grow if demand increases. I was really speaking about
a situation of increased competition with all else held equal.

------
quanticle
From the article: "Still others say their models simply failed to predict how
the markets would react to near-catastrophic, once-in-a-lifetime financial
events like the credit crisis and the collapse of Lehman Brothers."

The fact that they still believe those events were "catastrophic," or "once-
in-a-lifetime" means they still haven't grasped the fact that markets aren't
Gaussian. As first Mandelbrot, then others showed, financial markets exhibit a
much larger number of extreme events than a standard Gaussian distribution.
Therefore, any trader that doesn't update his or her models to use a non-
Gaussian model won't just be wiped out once. They'll be wiped out again and
again as they get blindsided by the "once-in-a-lifetime" price swings that
happen to happen every decade or so.

~~~
SkyMarshal
Indeed. For anyone that hasn't read it yet, Taleb's Edge essay on the nature
of randomness in 'Fourth Quadrant' domains is a good read:

<http://www.edge.org/3rd_culture/taleb08/taleb08_index.html>

And a more technical discussion of Mandelbrotian market models from Wilmott
magazine:

<http://arxiv.org/abs/cond-mat/0501292>

------
akshayubhat
does the analysis also includes HFT traders? Also I remember hearing that
Goldman Sachs didn't have a single day of trading loss. Maybe the smaller
Quant funds are loosing out on talent to the bigger firms?

~~~
retube
As a former trader, I can assure you that's bollox. No desk trading anything
has never had a losing day.

~~~
smanek
An individual desk might not, but it's not that unlikely for the firm as a
whole to.

~~~
retube
No, it's not. GS take big risk, they run large exposures as a bank. They'll
have their down days.

