| LONDON, June 8
LONDON, June 8 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
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,"
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
"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
"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