Quantitative Funds Suffer During Panics

It has been a long time since my last post. Sorry for the gap, but big life changes and all that. Pretty much the whole last year has been a bit crazy. Recently, I’ve gone outside my normal universe of investment to consider some mutual funds. While I do not have any specific recommendations relevant to my topic for today, I did learn some interesting things.

I was studying quantitative funds, which are basically funds that use a quant-driven approach rather than mixing that with a qualitative approach. It is not easy to find a fund that is purely in one direction. I do not think you will ever find a pure qualitative fund, but you can find a pure quantitative fund with some doing. More likely you will find one that leans more in a certain direction.

I was reading that 2013 was a great year for quantitative funds. They were in the top of their peer groups almost across the board. This means that if you are looking for some to put your money in and let sail away quantitative funds would have been a good bet. However, mutual funds tend not to draw the most active investors. You can invest in actively traded funds as a portion of your portfolio to try and generate some extra returns over the broader market. Quantitative funds tend to be active since the math governs the decisions, and the match changes day by day. Qualitative funds can make a judgment call and hold onto a declining stock or an appreciated but plateaued position. Quantitative funds follow their model.

Panic Situation

There is a reason to limit your exposure to active funds, but I want to talk about quantitative funds. If you feel drawn to that quantitative funds because of the great returns consider their apparent Achilles heel. In times of panic the quantitative models tend to suffer the most. There are many articles on this topic, but I just wanted to reiterate it. I have a thing against pure quantitative models, though on large scales they can be effective. So taking any chance to take a jab, I thought I would mention it again in this article.

The failure of the model is literally the lack of judgment that a pure math approach has. It cannot deal with panic selling. This is a situation where investors are throwing the baby out with the bath water. A human can look at an investment and decide that it is very strong despite the selling and hold onto it. Math shows no leniency. The 2008 crash was bad for quantitative funds. They tended to decline pretty severely.

I have heard people discuss quantitative models as being a defensive choice. The lack of emotion makes them a safer choice. I am not sure if that is true for milder declines, but it seems to be false for severe market weakness. So do not use a quantitative fund (or ETF) as a defense bit of your portfolio.

Opportunity?

You could also see panic selling as a chance to take a position in a quantitative fund. You’re not likely to catch a bottom, but do you need to? Probably not. I mean don’t rush in at the sign of any decline, but when no one has any hope you can swoop in. Riches are made in the worst times. You just need to make sure you have something to invest the next time the market tanks. Hence the reason not to use quantitative funds defensively. See in the end I had a strategy in mind all along.

I know this one is a bit light on the analysis. It is still interesting. Especially, because I am not overstating how much I’ve heard that quantitative models are meant to wax more conservative due to lack of emotion. Turns out the lack of judgment actually hurts them a bit.