Therefore, they are very good at trend following but hopeless at inflexion points. The losses at inflexion points — when the market or the economic indicators fundamentally change direction — will wipe out years of gains. Models always fail at inflexion points.
Thus smart beta strategies that have looked good for five years of low interest rates could now implode if, for example, rates rise faster than expected, currencies change direction, or inflation returns.
And it is at this point the nation’s pension funds will discover that when the IT underperforms, it underperforms by a lot.
Mathematical models don’t do near misses. All this might soon be put to the test. One of the more interesting theories doing the rounds at the moment has been developed by Charles Goodhart and the economics team at Morgan Stanley.
It focuses on demographics and suggests that most of the odd things in the world — the low returns, the lack of investment, the stagnation of incomes, the build-up of debt — have their roots in the near-doubling of the world’s labour force, starting from about 1970 when the post-war baby boom was followed by the integration of eastern Europe into the global economy and then the arrival of China.
The theory is that the near-doubling of the labour supply meant that its price dropped and lack of bargaining power meant inflation dropped.
It made sense to employ more people at home or in China rather than buy labour-saving equipment, so investment dropped. The decline in investment meant there was less demand for money, so interest rates dropped.
The fact that people were earning less — or at least not seeing their incomes rise as before — meant they borrowed more to maintain their standard of living. When they were maxed out on their credit cards and home loans and could not spend any more, demand dropped and growth dropped.
And that is where we are today. This is the new normal, the world of low growth, low inflation and low interest rates that poses such a challenge and has caused the investment world to embark on a frenzied search to find some magic formula which will allow it to invest profitably in a low-return world.
Hence its willingness to embrace all these quantitative strategies. When people have a need to believe, even Mystic Meg can seem credible.
But the key point is that the demographics are at a tipping point. The world is ageing and Goodhart says we are quickly moving from a position of labour surplus to labour shortage and if that happens, it could put all those key trends into reverse.
Wages will start to climb, investment will be revived, interest rates will rise quite sharply and inflation will become an issue again.
In other words, just as we are getting used to the new normal, the old normal is going to come back to bite us.
Given that all these computer models and trading strategies described earlier are backward-looking, how many will be positioned for this new world?
And, as has just been noted, they don’t do half measures. When they fail, they fail badly.
