A more detailed view of the Great Quant Meltdown of 2007

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The collective wigging out of the quantitative hedge funds earlier this month has been one of the most fascinating stories to come out of the market’s summer troubles. Joe Nocera wrote the best layman’s explanation in his NYT column on Saturday (a column that, I feel obliged to note because it makes me sound important, could not have happened without me, as I introduced Joe to his main source, AQR Capital’s Cliff Asness). Frank Ahrens had a less informative piece in the WaPo Tuesday (it’s a lot to ask of a man who covers the media and entertainment industries, and does it really well, to suddenly be an expert on quant investing). And today Barry Ritholtz has done the world the great service of collecting and posting the semi-apologetic letters the quant managers sent to their investors.

But all the coverage has been shrouded in mystery because these are hedge funds and they like to be mysterious. There are numbers about how much some of the funds were down, and talk that some of them have recovered most of the lost ground, but very little of the kind of hard information you could get if these things were run as mutual funds. But it so happens that there are a few quant mutual funds, several of them run by one of the pioneering firms in the field, Axa Rosenberg. I know because I own a couple thousand dollars of one of them, Laudus Rosenberg Global Long/Short Equity (RMSIX), and I’ve paid a couple of visits over the years to Axa Rosenberg’s headquarters next to the freeway in the lovely but dull San Francisco suburb of Orinda (just down the hill from the tennis courts where frequent Curious Capitalist commenter “Dad” spends a significant percentage of his waking hours).

So I checked out the charts on RMSIX and the older and larger Laudus Rosenberg U.S. Large/Mid Cap Long/Short Equity Fund (RMNIX), and they are indeed very interesting:

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The percentage drop isn’t nearly as dramatic as the ones you heard about at some hedge funds, because the Rosenberg mutual funds aren’t loaded up with debt like the hedgies are. Then again, the annual returns of the Rosenberg funds aren’t so amazing either: RMNIX is up 5.11% a year since its launch in 1998, RMSIX up 4.08% a year since its launch in 2001. But they’ve been steady returns, mostly uncorrelated with the overall stock market, during a tumultuous time for the market. Against the benchmark Rosenberg judges the funds by, 90-day T-bills, they’ve done quite well over time. I’m most curious as to why the global fund (the one I own, natch) still isn’t close to recouping all its losses while the domestic one is. (I’ll check with AXA Rosenberg to see if they have a clue and are willing to share it with me.)

This performance hasn’t attracted a lot of small investors–RMNIX has only $10.4 million in assets, RMSIX $3.3 million–and Charles Schwab, which markets the Laudus Rosenberg funds, is now planning to hand RMNIX over to Vanguard, whose customers presumably might be more inclined to buy such a product. (Axa Rosenberg will still manage much of the money, although Vanguard’s in-house quants will get part of it, too.) The quant hedge funds, with their leverage-enhanced returns, have had far more success in attracting big money from pension funds, college endowments and the like (as has Axa Rosenberg’s institutional side).

So here’s the big question: Does this stuff work? Or does the big drop demonstrate that the geniuses have failed yet again?

I lean toward the first answer, because the animating principle behind most of these quant funds, that you buy securities you like and sell short ones you don’t, has such a long and impressive pedigree. But just because a strategy works most of the time doesn’t mean it’s going to work all the time. And if you goose it with enough leverage, and don’t have a long enough track record to reassure your investors and lenders, you can be out of business before you know it, as Jeff Larson of Sowood Capital learned this month.

Famous long-shorters of the past include Alfred Winslow Jones and Benjamin Graham. Jones was a former Time Inc. employee who called the investment partnership he launched in 1949 a “hedged fund” because he followed such a strategy, and the name stuck. The great Graham was following a hedged strategy of selling common stocks short while holding the preferred shares of the same companies when the crash hit in 1929. He was convinced that the market was overvalued, but owning the preferred shares, which are less volatile than common stock, gave him some insurance in case he was wrong. He was right about the market being too high, and made a bunch of money in the crash. But afterwards he couldn’t bring himself to sell the preferred shares because they were so danged cheap, and when the market kept dropping he lost a lot. (This is all from Benjamin Graham: The Memoirs of the Dean of Wall Street.)

The quant version of this strategy, which I date back to math professor Ed Thorp’s entry into the investing business in 1969 but didn’t begin to gain many adherents until the 1980s and only really took off in the past decade, simply spreads the same approach over far more stocks or other securities, and involves much more frequent trading. My impression from the quants I’ve spent time with (Asness and the people at Axa Rosenberg, Barclays Global Investors, and Analytic Investors, among others), is that they’re basically value investors with a healthy respect for the market’s momentum.

This stuff is all very complex and computer driven, which makes it mysterious to laypeople, but because it involves fewer judgment calls it’s actually much easier to replicate on a large scale than the style of, say, Warren Buffett. There’s even a standard primer telling you how to do it, if you’re enough of a geek to understand it: Active Portfolio Management, by Barclays Global’s Richard Grinold and Ronald Kahn. (Grinold used to teach alongside Axa Rosenberg founder Barr Rosenberg at UC Berkeley and work for him at risk-assessment firm Barra, and Kahn worked at Barra too.)

What happened in early August was that too many people with copies of that book next to their Bloombergs did the same things at the same time. It was, as Goldman Sachs’s CFO later put it, a case “of the crowded trade overwhelming market fundamentals.” Which would seem to mean that the quant game might need to get a bit less crowded before it becomes a big winner again.

Update: Thanks to the alert reader (and quant) who informed me that I had the labels on my chart mixed up. It’s fixed now.

Update 2: The FT weighs in this (Thursday) afternoon with a story updating some of the performance data on the hedge fund quants.

Update 3: Guess I’m out of the quant investing game. Morningstar reports (second and third items) that the Vanguard Market Neutral Fund will require a $250,000 minimum investment and that my Laudus Rosenberg Global Long/Short fund will liquidate and return its money to shareholders on Sept. 24.

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