Kass: Revenge of the Nerds

NEW YORK (Real Money) --

"These nerds are a threat to our way of life."

-- Stan Gable (Ted McGinley), Revenge of the Nerds

The increased role of the quants (and high-frequency trading), the proliferation of double and triple ETFs and the rapid growth of market trading technology have replaced the last cycle's derivatives as the newest form of "financial weapons of mass destruction."

The democratization of trading has been the mantra of the algo and technology crowd since day one.

Nevertheless, I have been warning subscribers that speed kills, owing to the dangers of these strategies, products and technology, since May 2010:

One possible explanation for some portion of the recent large and random moves is the proliferation of momentum-based, high-frequency trading accounts and hedge funds.

While the role of the traditional stock investor is to assess the net present value of a corporation's earnings and share price, many quantitative funds deride the notion of fundamental value (and ignore net present value calculations) in favor of worshiping at the altar of price momentum. The momentum-based approach, which is generally auto-correlated, tries to find repeating patterns and generally extrapolate trends by going long what is in favor and going short what is out of favor.

It wasn't always this way. For some time, most quant funds attempted to be long value and short mis-value -- some still do -- but over time, many of their computer models changed into momentum-based programs, the purpose of which is to exploit a trend in motion.

Money (especially of an investment kind) goes to where it is treated the best, and the quant funds have been getting a lot of the marginal cash flow into hedge funds over the past several years. As such (and given their high-volume methodology), an increasingly large percentage of the trading on the NYSE is quant-program-related; by some measures, these strategies account for between 50% and 70% of daily trading volume.

The net of this is that quant funds control a lot of capital, they increase volatility (in both directions), and their investment style attaches little or no value to fundamentals; instead, they utilize algorithms that worship at the altar of price momentum.