Inside the Black Box: A Simple Guide to Quantitative and High Frequency Trading, 2nd Edition

CHAPTER 10

Risks Inherent to Quant Strategies

Torture numbers, and they'll confess to anything.

—Gregg Easterbrook

We have defined two broad classes of exposures: those that generate returns in the long run (alpha and beta) and are intentionally accepted and those that do not generate long-term returns (risks) or are incidental to the strategy. For the kind of quant traders that are the subject of this book, beta exposures are generally avoided (because they can be easily obtained by generic, low-cost index instruments), and therefore we can focus on alpha and risk exposures.

As we have already stressed, the kinds of alpha exposures quants seek to capture are generally exactly the same as those that are sought by discretionary managers. However, with any strategy there is always the possibility that the exposure from which returns are generated is not being rewarded by the marketplace at a given point in time. This risk of out-of-favor exposure is shared by both quants and discretionary traders alike.

This chapter will help an investor understand the types of risks that are either unique to quant trading or at least more applicable to quant trading. In a sense, we also are providing a framework for investors to design their own risk models that can be used to help determine how to use quant trading as part of a portfolio of strategies. The latter is a topic we address again in Chapter 12.

MODEL RISK

Model risk is the most basic form of risk any quant system brings to an investor. ...