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Liquidity crisis exposed weaknesses of large market neutral funds, says Sabre’s Hill

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The losses suffered last summer by some of the big quantitative funds, such as Goldman Sachs’ Global Alpha, illustrate the dangers of funds that outgrow the capacity of their strategy, acc

The losses suffered last summer by some of the big quantitative funds, such as Goldman Sachs’ Global Alpha, illustrate the dangers of funds that outgrow the capacity of their strategy, according to Melissa Hill, the managing principal of Sabre Fund Management.

The firm has attracted investment for the Sabre Style Arbitrage Fund from financial institutions, funds of funds, private banks and high net worth individuals, but Hill says: ‘We know that this strategy is a niche one and will not extend to running a multi-billion dollar portfolio.’

She argues that the losses seen last summer as liquidity dried up for asset-backed securities and market volatility spiked reflects the increasing reliance of large market neutral funds on leverage to shore up returns as alpha opportunities have declined due to overcrowding in common factor strategies.

‘It’s counter-intuitive to expect large managers to do well in the market neutral space if they’re following classic quantitative strategies,’ Hill says. ‘The anomalies [they exploit] are limited in size, so when the market becomes very crowded, the alpha is reduced. And if you are running very large positions because of asset growth and/or high levels of leverage you risk becoming a price setter instead of a price taker.’

Many parallels have been drawn between 2007 and the summer nine years earlier, when Russia’s sovereign default led to the collapse of Long Term Capital Management, but Hill notes that last year appeared very different in that the short-term spike in quant volatility was a contagion event, with problems generated in the sub-prime/credit area affecting quant strategies. This was perhaps a symptom of the growth in multi-strategy managers, many of whom operated quant strategies as part of their book and who will have had to sell good high-liquidity positions to meet margin calls.

‘The lower volatility environment of the past few years has led to a decline in returns from classic quant strategies, so funds have been levering up to meet investors’ return expectations or evolving into multi-strategy management,’ she says. ‘Sabre has taken the route of innovation within the strategy, being the first quant manager in Europe to pursue dynamic style rotation as a means of alpha generation.’

The Sabre Style Arbitrage Fund process incorporates a blend of strategies using varying time horizons that aim to deliver an ‘all-weather portfolio’. This highly diversified approach, combined with what Sabre calls its information advantage models – built using live data captured since 2002 – allows the fund greater flexibility in times of changing market sentiment.

Institutional investment, she says, has led to exponential growth for some managers, and investors should be examining whether some strategies are not better suited to being run by specialist managers whose size is better tailored to the market niches they are looking to exploit.

Specifically looking at August of last year, Hill notes that because Sabre Style Arbitrage has the flexibility to adjust its style exposures daily, it steadily reduced the importance of its value models in late July as this style started to underperform significantly relative to others. ‘When we reached the selldown on August 8, we had our lowest-ever value holding in the fund’s five years of live trading, which protected us from the worst extent of the sudden value/momentum inflexion,’ she says.

Some US quant managers also suffered disproportionately last year, Hill believes, because they share a similar career history and thus potentially a common investment and risk management approach.

‘The US quant industry is more mature than Europe and so some of the newer managers there have learned their craft in one of the premier names and then moved on, retaining a similar core approach,’ she says. ‘In Europe, by contrast, managers come from a variety of different backgrounds and so the strategies employed have different thinking behind them.’

She argues that in the light of last August, ‘perhaps investors should be thinking about the equity quant space in a different framework. Niche strategies can be high alpha ones and lower risk than perceived – especially when there is a long track record to point to.’

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