the Rise of quants: Exploiting the Moral Hazard

Moral Hazard

"Moral hazard exists when a party takes on risk without bearing the consequences of that risk" - Wikipedia

The Fed Put

"The Fed's pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices.  Investors increasingly believed that in a crisis or downturn, the Fed would step in and inject liquidity until the problem got better.  Invariably, the Fed did so each time, and the perception became firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking" - Alan Greenspan, Put Wikipedia

The Fed Put is a moral hazard because it sets up the conditions for speculation divorced from the risk realities of underlying securities. Over the last decade, macro quantitative programs and passive indexes have benefited from the Fed Put, have outperformed human analysts, and have come to dominate the misallocation of capital resources: 

"Investment funds managed by computers account for 35 per cent of the U.S. stock market and 60 per cent of both institutional equity assets and trading activity, according to a recent article in The Economist" - Brenda Bouw - October 10, 2019 - The Globe and Mail

 "The proportion of stock trading performed by human stock pickers has fallen from about 45% in the late 1990s to only about 15% today" - JPMorgan Chase & Co. 4/30/20

The Quant Mindset

 “The market is looking at a billion of things that we only know a very small amount of.... While the philosophical conversation is right in the sense that there should be some fundamentals relative to the price, how the market prices different fundamentals, different sentiment, different flows is pretty much a mystery to any one of us.”  Jeff Shen, Co-Head of Systematic Active Equity at BlackRock - Bloomberg - July 21, 2020

Perhaps it is a mystery because the equity market has largely become disconnected from the risk and return fundamentals of its underlying securities, having ceded the market to investors betting on macro sentiment and flow momentum.

A simple annuity risk/reward example:

Value now of a $1 annuity at a 0.7% interest rate

= $1/.007 = $142.

 Scenario 1: Rates fall to 0.5%

Annuity = $1/.005 =$200

 +41% Gain

Scenario 2: Rates rise to 2.0%

 Annuity = $1/.02 = $50

 -65% Loss

Picking up pennies in front of a steamroller.

Quantitative algorithms, with no moral compass, can add risk until the trend breaks. Humans, with a moral compass, may reduce risk to protect their clients from risk. The "Fed Put" insured that the trend never broke. The Fed assumed the risk. Speculation was rewarded. The stock market is now a policy tool of the FED. Turning points would be a bad time to own a quantitative fund.