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Among the lessons that August taught is that there may be a finite number of viable investing strategies–a suspicion borne out by the oddly synchronous decline of many quant funds this summer, including Simons’s Renaissance Technologies. August’s bizarre market behavior, according to Rothman and others, was probably the product of some large hedge funds’ seeking cash to meet their debt obligations, as the value of their CDOs declined, by selling those securities that were easiest to shed, chiefly stocks. (And which funds? In another example of the secrecy of fund managers, no one really seems to know, or wants to say.)

According to most of those to whom I spoke, something like the following occurred this summer. Quants had, in the ordinary nature of their jobs, “shorted” many stocks. Shorting is an arrangement whereby an investor borrows a stock from a broker, guaranteeing the loan with collateral assets placed in what is called a margin account. The investor straightaway sells the borrowed stock; if the stock then declines in value, the investor buys it back and pockets the difference in price when he returns the stock to the broker. But if the stock unexpectedly increases in value, even for a little while, the investor must either place additional collateral in the margin account to cover the difference or buy back the shorted stock and return it to the broker.

CDOs had functioned as the collateral on the quants’ short positions. When the subprime crunch squeezed the financial markets, the value of those CDOs declined, forcing quants to increase the collateral in margin accounts, buy back the shorted stocks, or both. But in either case, in order to supplement their shrinking collateral, quant funds were forced to sell strong blue-chip stocks, whose prices consequently fell. At the same time, as quants bought back shorted stocks, the prices of those stocks increased, demanding the posting of yet more collateral to margin accounts at the very time that the value of CDOs was suffering. That the quants were, apparently, long on the same strong stocks and short on the same weak stocks was a result of a number of strategies, pairs trading among them.

Another related explanation for the August downturn was that the quants’ models simply ceased to reflect ­reality as market conditions abruptly changed. After all, a trading algorithm is only as good as its model. Unfortunately for quants, the life span of an algorithm is getting shorter. Before he was at RiskMetrics, Gregg Berman created commodity­-trading systems at the Mint Investment Management Group. In the mid-1990s, he says, a good algorithm might trade successfully for three or four years. But the half-life of an algorithm’s viability, he says, has been coming down, as more quants join the markets, as computers get faster and able to crunch more data, and as more data becomes available. Berman thinks two or three months might be the limit now, and he expects it to drop.

For Richard Bookstaber, a quant who has managed hedge funds and risk for companies like ­Salomon Brothers and Morgan Stanley, the August downturn proved that concerns he’d long harbored were well founded. ­Bookstaber was on the panel sponsored by the IAFE; in fact, he is everywhere these days. His book A Demon of Our Own Design, which appeared in April, was eight years in the making, and it made some very prescient predictions.

Bookstaber is a quiet, thoughtful man, with sharp brown eyes and an attentive look. He studied with Merton in the 1970s at MIT, where he got his doctorate in economics. Today, he is very worried about the tools and the methods of the quants. In particular, he frets about complexity and what he calls “tight coupling,” an engineer’s term for systems in which small errors can compound quickly, as they do in nuclear plants. The quants’ tools, he feels, have became so complicated that they have escaped their creators. “We have gotten to the point where even professionals may not understand the instruments,” he says. This, to Bookstaber, was perfectly demonstrated this summer, when the subprime troubles touched off a reactionary wave of selling in equities that would nominally seem unrelated, or, as Wall Street puts it, “uncorrelated.”

“Nobody knew that what happened in the subprime market could affect what was going on in the quant equity funds,” he says. “There’s too much complexity, too much derivative innovation. These are the brightest people in the business. If it could happen to them, it could happen to anyone. No one could have predicted the linkage.”

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Credit: Julien Pacaud

Tagged: Business

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