Investment Initiatives » Against Quantitative Trading

11.06.11

Against Quantitative Trading

Posted in Blog at 5:24 pm

  • I wrote this in response to a thread on LinkedIn, on which Mark Rome raised the question, “Is it Time for a Market That Prohibits High-Frequency Trading?”  regarding ETFs and all sorts of quantitative techniques, as well as HFT itself, on 5 November 2011:

I’m afraid that most of this discussion loses sight of the real issues. Liquidity is not an end in itself. Cheap execution is not an end in itself. And I’m afraid that huge bonuses are not the goal of capital markets, either, although they are wonderful to bring home for the trader him/herself. In fact, much of the money made from trading is merely a form of rent extraction, which means it is raising costs for everyone else, there is no net gain, and probably a net loss.

Capital markets exist to bring together natural lenders of money with those providers of goods and services who by their very nature have a constant need for capital. All the rest of our market activity is derivative of this basic function. Savers (investors) have long believed that they can get an excess return on their investments if they invest their money intelligently, and this has given birth to a huge industry in search of these excess returns. Unfortunately, not every technique works consistently, and none works over every time period, so there is a constant search for new techniques. It is in the interest of the general economy that markets allocate money to those investment opportunities which will lead to the greatest amount of net economic gain for their owners, and therefore the highest returns for investors. This is the real meaning of efficiency.

Quantitative techniques are a way of gaming the system so that one tries to get a positive return no matter what is going on in the real world of the economy, by looking at correlative market events having little or nothing to do with the general economy. They are at best, a sideshow to the main event. Unfortunately, because such gains are inherently minuscule (if they exist at all) on any one transaction, they must be multiplied by vast volumes of trading, or by using huge amounts of leverage, to make them worth anyone’s while. This often leads to excess volatility, especially at times when the market lacks clear direction. If there are hidden risks, which were not properly accounted for in the trader’s algorithm, they can cause enormous losses, and perhaps even start panics.

There are always going to be people who are looking for a way to get a free lunch, including those who believe, despite all the principles of science, that there is such a thing as a perpetual motion machine, that it is possible to turn lead into gold, that one can find a chemical or physical reaction which results in a net gain of both mass and energy with no entropy loss, and that it is possible to make money on the stock market without doing one’s homework, and finding something truly undervalued. Historically, in the grand scheme of things, such people were relatively harmless—perhaps they defrauded a few investors, but that was all. Unfortunately, with the vast amounts of leverage now commanded by some traders through the magic of derivatives, this quest for the the gimmick that gives one a free lunch can become very expensive indeed.

Portfolio insurance was a fraud, which directly led to the market crash of 1987. Long-Term Capital Management had run out of gimmicks, so they started gambling on naked risk arbitrages with huge leverage, and caused a market panic in 1997. Collateralized Debt Obligations were a fraud which caused the great credit crisis of 2007, multiplied by the leverage offered by CDS, which accelerated the crisis. All of these quantitative strategies were supposed to make markets more efficient; in the end, they all led them astray. I think that regulators need to stop giving all arguments for increased liquidity a free pass. There is such a thing as excess liquidity, and just as seawater sloshing back and forth on the deck of a Roll-On-Roll-Off auto ferry caused it to sink, excess liquidity careening back and forth within markets causes frightening volatility, scares off investors and borrowers alike and can cause crashes. It needs to be brought back within rational limits.

 

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