Beat the Eggheads at Goldman Sachs!

August was an awful month for quants -- the folks who buy and sell based solely on numbers. The Goldman Sachs (NYSE: GS  ) Global Equity Opportunities fund lost more than 30% in a single week, and the ACI U.S. Market Neutral Fund run by Algert Coldiron Investors reportedly lost more than 19% through Aug. 24.

How many quants can fit through a single exit?
How did this group of brilliant, pedigreed investors go wrong? Citigroup diagnosed this "quant fever" in an Aug. 9 report: "A Challenging Environment for Quant Strategies."

Quantitative strategies involve picking groups of stocks based on fundamental or technical factors such as P/E ratio, projected earnings growth, or previous month's return. According to Citigroup, in the latter half of July and the beginning of August, at least two trends emerged:

  1. The correlation between different factors increased.
  2. There appears to have been a shift in some of the major style factors (from small cap to large cap, and from value to growth).

These were compounded by the fact that quant funds found that their strategies were more "crowded" than they had anticipated. In those circumstances, a sudden liquidation by a fund or proprietary trading desk would have caused further sales as price declines triggered margin calls by funds' prime brokers.

Need more detail?
Here's an illustration of what can go wrong:

You're a quantitative fund manager at Perditio Capital Management. You decide to make a simple bet on short-term price reversal in August by ranking the stocks in the Russell 1000 index in terms of their performance in July. You then buy the worst-performing stocks (the bottom decile), expecting that these laggards will come back with a positive performance in August.

For good measure, you also sell short the best-performing stocks (the top decile) -- surely these front-runners can't sustain their July run-up and will give up some of their gains.

July Return

August Return

Sepracor (NASDAQ:SEPR)

(31%)

4%

MGIC Investment (NYSE:MTG)

(32%)

(22%)

Radian Group (NYSE:RDN)

(38%)

(48%)

Bottom Decile (Total)

(17.8%)

(4.1%)*

*For an equal-weighted portfolio. Does not include the effect of dividends.Source: Standard & Poor's Capital IQ, Motley Fool Research.

And the stocks you sold short:

July Return

August Return

Intuitive Surgical (NASDAQ:ISRG)

53%

4%

Dade Behring (NASDAQ:DADE)

41%

1%

CROCS (NASDAQ:CROX)

38%

0%

Top Decile

10.8%

0.6%*

*For an equal-weighted portfolio. Does not include dividends.Source: Standard & Poor's Capital IQ, Motley Fool Research.

Put the two together and you ended up losing 4.7% in August. That might not sound disastrous, but if you multiply that by a factor of 6 (the approximate degree of leverage of Goldman's Global Equity Opportunities fund prior to its recent cash infusion), it's little wonder that your managing partner has asked to see you for a "quick chat."

The individual investor's edge
The good news is that there are easier ways to make money. Just because the eggheads had a hard time coping with last month's market conditions doesn't mean that there is no hope for the ordinary investor. In fact, you and I have a few advantages over the quants -- as long as we:

  1. View stocks as ownership interests in a business, not just a collection of risk factors.
  2. Embrace a longer time horizon and accept volatility.
  3. Ignore the siren song of leverage.

Over the long term, stock returns will be dictated by the economics of the underlying business. In the short term, stock returns, or indeed the risk factors that quants use to model those returns, are fiendishly difficult to predict. What's more, due to the pressure of the business, quant funds try to enhance those same fiendishly-difficult-to-predict returns by borrowing money. When returns turn negative, leverage acts as an anchor.

Use your edge to profit
Professional investors are evaluated on a quarterly and even monthly basis. As an individual investor, you're not subjected to that, and as long as you keep your long-term financial goals in mind, you don't need to suffer from a phobia of volatility.

Indeed, using leverage and focusing on the short term is like showing up to a swim meet with your hands handcuffed behind your back.

At Motley Fool Inside Value, we adopt a multiyear time horizon with our investments and are willing to accept volatility and periods of underperformance (in some cases, fairly lengthy ones) in the pursuit of superior long-term returns. We apply our value investing framework diligently and endeavor to buy equities for less than their intrinsic value.

If you'd like to find out what we think are the best places for new money in this period of market upheaval, take a free trial to Inside Value (no purchase necessary).

Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Intuitive Surgical is a Motley Fool Rule Breakers recommendation. The Motley Fool has a disclosure policy, outlined here.


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