Ukraine conflict reminds quants that operations matter

For systematic investors, the war in Ukraine has served as a reminder that real-life market frictions can make a fool of even the most carefully designed strategies.

In the wake of the invasion, investors have grappled with the fallout from the economic sanctions imposed on Russia.

Market moves have largely cancelled out, with hits to some assets offset by gains in others, notably commodities. Certain strategies have come unstuck. But others have flourished.

What tripped up most investors were the operational pitfalls posed by the sanctions. The difficulties ranged from pricing anomalies and exchange closures to exploding margin calls on commodities. Such possibilities are rarely considered when quants formulate new alpha strategies, but they have the potential to confound the most elegant ideas.

Much of the “real” work in systematic investing, says Joris Tolenaar at quant firm Transtrend, actually has to do with operations. “It’s not where you win the game,” he says, “but it’s where you can easily lose.”

It’s a time-worn lesson. Margin calls brought down LTCM. (The consortium that took on the positions of the storied hedge fund turned a profit.)

Frictions of this nature are more common than investors might realise.

In 2021 the US imposed restrictions on US firms trading securities linked to companies believed to have ties to the Chinese military, leading to those instruments also being removed from MSCI’s global index.

Spain and Italy banned short-selling in some stocks in 2020 as Covid-19 caused equity markets to crash. Sanctions relating to Russia’s annexation of Crimea in 2014 created problems for banks trading FX futures at the time.

Refco – the world’s then-biggest independent futures broker – collapsed in 2005, leaving its clients scrambling to transfer business elsewhere. Malaysia effectively froze offshore ringgit assets during the Asian financial crisis in 1998.

The concern for quants is that such market frictions are essentially ignored in the backtests they use to validate strategies. That means strategies that would have been impossible in practice can look promising in tests.

As an extreme example, a quant today might assume that systematic trend following in 2008 was easy, as markets dived. In truth, most investors at the time were concerned about wiring money to counterparties that might not exist the following day. Counterparty risk trumped market risk. Trends were “on fire”, Tolenaar says. “Unfortunately, the banks were on fire too.”

Likewise, 20 years from now a strategy that in backtests shorted Russian stocks in 2022 might look like a winner. Should that happen, it would be wise to recall that in recent weeks those stocks have been effectively untradeable for most investors.

How might quants try to capture these effects in backtests or build a trading system to handle them? The truth is, they can’t. Operational problems are a fact of life and inevitably require human intervention.

The war in Ukraine is prompting investors to consider how geopolitics might reshape the international financial system. For systematic investors, it should remind them to trust their backtests a little less.