What Happened to Diversification?

August 24, 2007 |

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Matthew Rothman at Lehman Brothers recently published a research piece in order to explain why market neutral/statistical equity arbitrage funds were getting trounced in July and August.  In short he concluded that a massive unwind of positions by multi-strategy funds and other forced sellers has caused systemic perverse performance of factor models (i.e., even though value investing makes a lot of sense, it’s not working).  So the real noodle scratcher here is that there are hundreds of quantitative hedge funds and prop desks with fancy, “differentiated” models and all sorts of bells and whistles, but at the end of the day, after all of the hocus pocus, most funds have the same long and short positions.  Has no one been able to build a better mouse trap, or is everyone still buying into the old University of Chicago value and momentum approach?  Whatever happened to artificial intelligence, principal component analysis, correlated pairs, and all of that other jazzy stuff?  Hey, they may not have always worked, but at least they were differentiated and added real diversification to portfolios. 

A word of advice to budding start ups: make sure you are really differentiated.  Before you launch, speak with your potential investors, learn what’s in THEIR portfolios and determine how your system can diversify and enhance their overall program, and then tweak if you have to.  Index product is becoming more abundant and cheap; think hard about how you will compete.

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