The Pursuit of Edge
In our most recent guest blog for the Quant Conference, we discussed ‘The Evolution of Quant Strategies.’ In that piece, Andrew Perrins, CEO of Savvy Investor, argued that, “the pursuit of statistical edge was one of the raisons d'être for today’s quant researcher”.
Following up on this theme, Andrew examines the pursuit of edge as it applies to financial markets. He observes statistical traits in both the sporting and financial world and how the recent effects of Covid-19 may have implications for financial market data sets.
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Forget the Beatles: Quants Reign in Liverpool
Liverpool Football Club have everything going for them. Led by a well-respected head coach in Jurgen Klopp, a proponent of ‘heavy metal football’, and possessing a superstar player in ‘The Egyptian King’, Mo Salah, they are the reigning champions of Europe and World Club Champions. In the current season of the English Premier League, they’ve so far* racked up 82 points from a possible 87 — a success rate of 94.3%.
For our US readers familiar with the NBA, Liverpool are beginning to look just as good, if not better than the Chicago Bulls team of the early 1990s. Chicago’s head coach, Phil Jackson was a practitioner of the enigmatic ‘triangle offense’ and the team was built around arguably the best player of all-time, Michael ‘Air’ Jordan. The Bulls dominated the NBA in the nineties winning six NBA Championships and set a league record of 87.8% wins in the 1996 regular season.
Looking at Chicago and Liverpool in simple terms, we can observe two successful traits:
1. A star player.
2. A respected head coach with a unique style or strategy for playing the game.
For the layman, it is clear both teams have demonstrated great success. However, for those with a quant mindset, you might be asking why Liverpool’s win stats are almost perfect? Why are they dominating world soccer? From where does this winning edge originate?
The authors of the club’s current 94.3% winning edge are: Ian Graham, William Spearman, Tim Waskett and Dafydd Steele — the Liverpool Football Club quants.
What is Edge?
Edge may be an abstract term written in the singular, but in truth, edge is merely the sum of synergistic winning traits. In Liverpool’s case, the team’s collective edge can be attributed to a trinity of ‘mini edges’:
1. A star player.
2. A respected head coach with a unique style or strategy for playing the game.
3. A dedicated team of quants measuring, mapping and modelling all aspects of the game.
So, if the basic principles of edge can be obtained in sport, can these same principles be applied by quants pursuing edge in financial markets?
Financial Edge Sources
In finance, it can be argued that in order to develop a competitive edge over other market participants; a strategy ought to be unique, identifiable, repeatable, measurable, and deliver a profitable outcome over time.
As we highlighted in our previous blog post, some strategies such as trend following have fallen out of favour in recent years as returns have disappointed. As a result, quantitative researchers have had to adapt to discover new avenues of opportunity.
For those wishing to verify the uniqueness of their own strategy, Kakushadze and Serur’s 151 Trading Strategies offers a comprehensive compendium of trading approaches across asset classes and demonstrates that are many ways to play the financial game — certainly from a quantitative point of view.
Qualitative Edge
Although Kakushadze and Serur’s work does cover some strategies with a qualitative approach, we await more research in this field. One area that is witnessing the early stages of edge creation is strategy development via the BIN model. Standing for ‘bias, information and noise’ and espoused by academics such as Kahneman, research performed by Morgan Stanley Investment Management has indicated that noise (measured by the variability in expert judgement) could be an area of edge development in the future. Researchers willing to build models to measure and map these three human traits as they pertain to financial market decision making may find that Kahneman was quite right to say, “algorithms are noise free; people are not.”
Although, some may argue that poker is not a sport per se, the mapping of player behaviour at the card table can provide some valuable insights. As Annie Duke, a poker player who wrote the book Thinking in Bets discusses in a recent AQR podcast, if a player can think about not only their own strategy, but also how their opponent’s strategy might impact them, then this can provide an exploitable edge. In financial markets, it may therefore literally pay to model the behaviour of poor performing strategies in order to identify a different route to profitability.
Quantitative Edge
For most quants however, the real truth is in ‘the numbers’. Yet, with a multitude of strategies fiercely competing for investment returns, ‘edge erosion’ is never too far away.
In normal market conditions, this erosion can be gradual. However, in times of market stress and as noted in Candriam’s quant podcast, the erosion of edge in March 2020 of crowded strategies such as ‘long small caps, short blue-chips’ was telling. This raises the question of how to pursue edge over time whilst simultaneously being able to survive aberrant market events and even benefit from ‘crisis alpha’.
The CFA Institute provides some colour on the regularity of multi-sigma events, which contextualises the likelihood and regularity of market dislocations over time. Fortunately, for equity index strategists, these events are statistically rare. Still, when confronted with price spikes as a result of exogenous market shocks, researchers can be forgiven for thinking that an historical data set needs be adjusted. Chandrashekaran’s work on the 1987 crash addressed this point in a simulation study that included the month of the crash, stating that the crash itself did not have a significant effect on the ex-post information ratios of a market timer.
Gamma Radiation
Since the introduction of VIX derivatives in 2004, a case can be made for the ‘derivatives tail’ being partly responsible for ‘wagging the cash’ prices of financial instruments in recent years. The Society of Actuaries presentation on ‘The Market Impact of Dynamic Hedging on Hedging Program Performance’, illustrates this acutely as insurers play an even larger role in the derivatives market as they attempt to hedge and manage the optionality of their long-term liabilities. Although not widely reported at the time, their presentation estimates that during the taper tantrum of August 2015, “hedging flows for S&P 500 put options and delta hedging of variable annuities may have amounted to 40% of total market gamma”.
With this in mind, and as researchers devise new strategies for the future, the extent of this gamma phenomenon and the tendency for the market to respond drastically to it ‘flipping’ from positive to negative and vice versa, may become the next route to edge discovery. For quant researchers, and as noted by Artemis Capital Management in their much-respected paper, ‘Volatility and the Alchemy of Risk: Reflexivity in the Shadows of Black Monday 1987’, there may be value to be found in deciphering to what extent volatility “is now a player on the field”.
Summary
There are many parallels between sport and finance. Put simply, both can be viewed as competitive pursuits with the difference between winning and losing boiling down to the exploitation of the finest of margins. To achieve success, quants must be able to identify and harness these fine margins or ‘mini edges’ finding ways to operate them synergistically ahead of the crowd.
To that end, and as we look to the future, it is safe to say that the ‘pursuit of edge’ still remains one of the raisons d'être for today’s quant.
For managers and researchers wishing to stay up to date on thought leadership and research in quant and the world of finance, please join us at Savvy Investor. It is a knowledge network for global institutional investors which aggregates the best investment white papers from across the investment industry. Papers are intelligently tagged, categorised and rated, allowing our 46,000 members to quickly and freely search and identify the most popular content on any investment topic. Thank you to George Rowe for his assistance on writing this article.
* At the time of writing this article, the Premier League season had been suspended due to Covid-19.