June 8, 2012 / 8:47 AM / 5 years ago

Computer trading models crash from favour

LONDON, June 8 (Reuters) - Investors are losing faith in the computer-based trading models that made them millions in the bull market years, as Europe's financial convulsions have shown how poorly they cope with the unpredictable.

Once beloved of funds dealing in scores of securities across the globe, the sovereign debt crisis and its daily assault on markets have exposed weaknesses in the 'black box' investment approach, now seen by some as a liability rather than an asset.

A realisation that risk cannot always be measured and conspicuous failures to foresee sharp market moves is prompting a return to manager-led strategies, and in some cases, hiring of new talent with expertise in areas such as political analysis.

"This is where we are, which is a potentially dangerous position, where politics for the first time in 50 years becomes pertinent to markets," said Saker Nusseibeh, head of Hermes Fund Managers, which is owned by Britain's largest pension pot, the BT (British Telecom) Pension Scheme.

Currently many of the risk models used by investors are based on the analysis of volatility and correlations of traditional asset classes such as equities and bonds, but critics say this needs to be tempered by an assessment of the safety of the asset by a well-informed analyst.

"True skill is actually rarer than people think, so if you happen to be an organisation that has that, you can command a premium. The skill is in recognising disruption, particularly in recognising that the old rules no longer apply," he said.

Nusseibeh believes the financial industry is not equipped to understand a world shaped by prolonged financial crisis, having relied for many years on models based on assumptions and past observations that can no longer be depended upon.

Manu Vandenbulck, a senior investment manager at ING Investment Management, takes as an example the indexes of dividend-paying stocks that many fund managers used as benchmarks.

Before the financial crisis of 2008, these indexes had become heavily concentrated in financial company stocks because of the sector's strong record of dividend growth.

Those who built portfolios in line with these indexes were painfully exposed to the sector, which was hit hardest when U.S. investment bank Lehman Brothers collapsed in 2008.

"Qualitative active management has proven more sensible," Vandenbulck said.

BUMPER YEARS

After years of bumper returns by the likes of Man Group's computer-driven AHL fund, the financial industry grew increasingly confident in the ability of its models to predict big market movements, but most failed to spot the coming turmoil.

"In the current environment your risk is not much linked to the type of asset you are holding but more to the crisis that you are facing," said Edouard Senechal, a Chicago-based investment strategist at U.S. financial group William Blair.

Senechal has sought to develop a model that incorporates qualitative input and moves away from "a pure quantitative aspect of risk management".

"We still use models as reference framework. However, we are willing to set the inputs in our model qualitatively, and that is what allows us to pick up on the market changes that are coming very, very rapidly," he said.

"If you analyse a Spanish bond as a safe asset - which is how they have been behaving all the way up to 2010 - then this is not the right analysis," Senechal said.

The shift in sentiment echoes a 'manifesto' written by academics Emanuel Derman and Paul Wilmott in the wake of the financial crisis in 2009, which noted traditional valuation models had been found wanting and a broader approach was needed.

"Financial markets are alive, but a model, however beautiful, is an artifice ... To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules," the authors argued.

Derman is Head of Risk at Prisma Capital Partners and a professor at Columbia University, where he directs their programme in financial engineering.

Speaking to Reuters from New York, he said it was "salutary" to highlight the limitations of modelling.

"There's no mechanical formula that's going to save you from people's panic and contagion. I think some people understand that, but there are also some people who perhaps haven't got capital markets experience and put much too much faith in the models," he said.

"I think you have to use models, but you have to understand that all bets are off when the world really gets hectic, and volatility is going to really destroy your model."

Some fund managers caution, however, that moving too far away from quantitative analysis in favour of more qualitative approaches can leave performance vulnerable to over-reaction to political headlines, false storms and short-term trends.

"Qualitative overlays should be applied for risk control purposes only, not for taking directional views on countries, stocks, sectors or factors," said Jenya Emets, a senior investment manager of Global Enhanced Equities at State Street Global Advisors.

"Quants should focus on what they do best - exploit over (or) under reaction and other market inefficiencies in a disciplined fashion and remove unintended risks from their portfolios."

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