Was Warren Buffett Right About Quant Hedge Funds?

The last several years have been difficult for hedge funds, although November was their best month in over ten years. Despite that, they still under-performed major indices. Data from Eurekahedge reveals that hedge funds, in general, were up 4.49% on an equal-weighted basis and 3.51% on an asset-weighted basis, with long/ short equity funds leading the way.

Actively managed funds beat quants

Actively managed hedge funds beat quant funds in 2020. Quant funds have dominated actively managed funds for years, but human stock pickers won the year in 2020, driven by tech stocks preferences and a flood of stimulus money from central banks.

Firms like Tiger Global, Coatue and D1 recorded returns more significant than 35%. Meanwhile, even the most sophisticated quants like Renaissance Technologies and Two Sigma struggled as their computer models tried to deal with wild swings driven by geopolitical uncertainty.

Saba was up 74% in 2020, while Bill Ackman's Pershing Square gained 66%. Whale Rock gained 71%, and Coatue gained 58%. The best-performing funds won by investing in tech and private startups. However, the market's wild volatility made quants among the biggest losers in 2020. Renaissance was down over 30% for 2020, while AQR lost 22%.

Many quant funds were already starting to struggle even before the pandemic struck. Several of them had gotten so big, into the tens of billions of dollars, that any inefficiencies their computers detected in the market often disappeared before they could make much money from them. Jon Caplis of PivotalPath told Bloomberg that most quant strategies haven't even made much money in "several years."

What Warren Buffett has said about quants

Warren Buffett has spoken out on quant funds or the technology that drives their stock picking. In his 1987 letter to Berkshire Hathaway investors, he said he didn't think computers would be the future of making a profit in the markets.

"In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets," Buffett wrote. "Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace."

When he made that statement, Buffett may not have envisioned just how high-tech stock picking would get. He remarked well before the dotcom bubble, although Buffett isn't called the "Oracle of Omaha" for nothing.

Why Buffett didn't think computers would be the future

He went on to explain why he didn't think computers would be the future of stock picking. Buffett allows the companies' operating results to tell him whether his investments are successful.

"The market may ignore business success for a while, but eventually will confirm it," Buffett explained.

He added that the speed at which a company's success is recognized isn't essential as long as its intrinsic value grows at a satisfactory rate. Further, he said delayed recognition can be a good thing because it gives active stock pickers a chance to buy more of a good thing at a bargain price.

Buffett also had something to say about the use of computer formulas in a later Berkshire letter. He advised investors to "be skeptical of history-based models." He told investors usually forget to study the assumptions behind the models.

"Beware of geeks bearing formulas," Buffett said in his 2008 letter to investors.

The problem with quant funds is that their stock-picking tends to be at least in part based on history-based models. Thus, as 2020 has shown, they aren't ready for significant dislocations that appear out of thin air in the computers' "minds." Computers weren't able to predict the pandemic, and they won't be able to predict other significant events, which shows that human stock pickers still have their place in the world of trading.

After years of success for quant funds, Buffett’s old fashioned approach won in 2020.