Cliff Asness of AQR Capital Management, one of the hedge funds briefly caught in the Great Quant Meltdown of August 2007, has been sending around a “working paper” that attempts to explain what the heck happened. As with everything Cliff writes, it’s more entertaining than an explanation of quantitative investing has any right to be. (Although be warned: It’s still an explanation of quantitative investing.) A few highlights:
Q. How do you know the problem was “deleveraging” vs. just bad stock picking?
… First, the very size of the moves. The world is highly “fat-tailed”, meaning very big events happen more often than most models assume (the so-called “Black Swan” problem), particularly at short horizons. This is not something we just discovered; it always has affected the sizing of our bets. …
Second, the linear nature of the declines and the comebacks. When they were falling and then when they were rising, these strategies moved in a near straight line throughout the trading day. It looked just like what it was – someone working large orders to take down their risk – and then someone putting that risk back on. It did not look like the random losses or gains of getting many small bets right or wrong.
Third, models are composed of many factors, some of which are low or negatively correlated with each other (value and momentum are the most prominent example of this phenomenon). During this period, all of the more well-known factors performed very poorly. That is a sure sign people were taking down risk in similar models….
He actually gives a fourth reason, but it’s pretty closely related to the third. Then there’s this:
I have said before that “there is a new risk factor in our world,” but it would have been more accurate if I had said “there is a new risk factor in our world and it is us.” It is our collective action going forward (where “our” refers to quant market-neutral managers or those employing very similar strategies) that now affects a world we didn’t realize we had such influence over, and this is undoubtedly an important short-term risk factor.
Q. On the night quant equity strategies hit their lows, how did you feel getting a phone call from Ken Griffin of Citadel?
I looked up and saw the Valkyries coming and heard the grim reaper’s scythe knocking on my door. I did my best to run to the light.