Saturday, August 11, 2007

What’s Going On with the Quant Hedge Funds?

There are a host of very large and well-managed quantitative equity funds that are up against the ropes, all seeing big losses at the same time. And these are market neutral funds that spend a lot of time and resources monitoring risk and systematic exposure. They try to avoid taking market bets. They also try to avoid large exposure to other systematic factors like interest rates or credit spreads. Yet they are all getting hammered. Why is this happening?

If I were to venture a guess – and it can only be a guess, because I do not know the internal workings of these funds – I would look at three culprits.

First, quantitative funds are highly levered. The modus operandi for quant funds is to find small price anomalies and turn them into meaningful returns by applying a lot of leverage, so they end up with many times the leverage of most fundamentally-driven equity hedge funds. As I point out in my book, leverage is the raw material for just about every market crisis. When a fund is highly levered and things start to go bad, it might get a call from its prime broker informing it that its collateral has dropped to the point that it no longer have enough assets to meet the required haircuts. If that happens, the fund – and others who are in the same boat – will be forced to start selling assets to reduce exposure. The selling drops prices, so the collateral declines further, forcing yet more sales. And so goes the downward cycle.

Second, they have strategies in common. This should not be surprising, given that many of these funds share a common lineage: Goldman’s Global Alpha Fund and AQR; Tyke and DE Shaw. The bread and butter strategies for many of these larger quant funds are momentum and stock valuation, with some factor-based allocation strategies sprinkled in. There aren’t a whole lot of different ways to measure momentum, so what one firm considers a high momentum stock is likely to have been similarly tagged by other firms in the game. The same is true with stock valuation and factor strategies. Valuation is modeled using factors like free cash flow, earnings quality and analysts’ earnings estimates. While there may be nuances in how you do this, you can only twist these sorts of data around so much. So at the end of the day each of these funds will be long and short similar sorts of stocks – if not the exact same stocks.

Finally, in aggregate these quant funds may be operating beyond the capacity of the markets. Well, right now that is pretty much true by definition, since it seems they can’t get out of each other’s way while they try to liquidate. But even during less crisis-prone times, the money employed by these strategies might be more than the market can absorb. One indicator of a capacity problem is the performance of these funds over the last few years. They have not been doing very well, which suggest there might be too much money chasing the opportunities. And it might be that their alpha has been dropping even as they have been increasing their leverage. If so, then the market opportunities are drying up even more than the performance would suggest. Hedge funds have to measure capacity – how much money they can effectively put in a strategy – by looking at the total capital being applied to the strategy they are pursuing, not just what they are putting to work in their fund. You need to take all of the quant funds employing the momentum-cum-valuation strategies and multiply their capital by the leverage they employ, and only then start asking the capacity question.

The quant fund crisis is as close as it gets to a pure example of the point in my book that it is liquidity and market dynamics, not economics, that spawns market crises. These are funds that invest substantially in talent and systems, and focus on keeping clear of anything systematic. Yet they are embroiled in a liquidity crisis. If it can happen to them, it can happen to anyone.

8 comments:

  1. Enjoyed reading "Demon" and your blog. Your current post title and media reports seem to be concentrating on the "Quant" hedge funds as being the hard hit type.

    In Ch.11 "Hedge Fund Existential" -- you discuss the difficulties in defining Hedge Fund entities. Is "quantness" any easier definable than "hedgefundness" [p.243]?

    Would I be correct in interpreting from your post that it pretty much boils down to those higher-levered funds holding less liquid instruments and/or employing a strategy that events have caused to exceed market-capacity?

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  2. Further to these points is the unanticipated tight coupling with other markets introduced by larger multistrategy funds. Leading theory on the street seems to be that one or more multi-strat funds needed liquidity to deal with the credit crisis. The easiest source of liquidity is usually in their quant strategies, so they dumped a bunch of those positions -- which, as you noted, would have moved the markets exactly against similar quant funds.

    Those independent funds, seeing the unanticipated increase in volatility and decrease in value in their positions, may have had to delever to maintain risk parameters, producing the vicious cycle we're now calling the "quant crisis." The WSJ also has an interesting article on the valuation anomalies being introduced by this "quant unwind."

    Essentially, a bunch of big liquidity providers temporarily stepped away from the markets. However it shouldn't take long for others to step in.

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  3. Its amazing to me how often these patterns repeat. It seems we have one of these meltdowns every 10 years or so.

    Someone should buy these leveraged fund managers a copy of The Black Swan!

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  4. As a EMN model developer, I think one of the biggest issue was over-reliance on just two themes: Valuation & Price Momentum. Other ancillary factors such as Earnings Growth, Accelerating Sales etc were anyway always correlated with either of two. So, we had basically models which even though apparently had 20-40 factors actually are more like just 2 factors - and then the extreme leveraging coupled with both the 2 key factors decided simultaneouly to work very poorly made the situation into a snow-ball.

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  5. Curious how the author would go about estimating the amount of capital allocated to these quantitative valuation and momentum strategies.

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  6. Seems to me the momentum/valuation quants are trading old school whereas those quants that feed off the old school quants have done very well the past couple months. Just an outsider. What's your read on this idea?
    John
    www.DayTradersWin.com

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  7. Jim Simons' Medalion Fund wasn't mentioned, this guy is #1 in the industry of quants! I bet you even know some of the MIT professors who work there.
    cheers

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  8. When price makers are forced to be price takers, bad things happen. The opposite is not true.
    The root cause was a pari passu of positions as you mentioned plus a sudden demand for liquidity from capital accounts that weren't getting it elsewhere. The ripple creates higher risk measures, which in turn force de-leveraging to risk limits and the merry round goes again.
    Large temporal shifts in covarience are usually a good sign that liquidity is being demanded as opposed to emerging factor returns.

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