How the Next Quant Fund Crisis Will Unfold
Markets are vulnerable.
Most everyone knows that this month marks the ten th anniversary of the begin of the fattest financial crisis since the Excellent Depression. There was another significant event back then that gets overlooked but was still very significant. one  I’m referring to the quant equity crash of August 2007. two
It was abate by comparison to what else was going on at the time. It lasted three days, and markets snapped back on Day Four. Albeit many funds lost as much money in three days as they were supposed to lose in a bad year, there were no instantaneous blow-ups. three Ultimately, tho’, about a quarter of quant equity funds calmly closed a year or more later, including the Goldman Sachs Global Alpha fund, as almost two-thirds of assets invested were withdrawn over the subsequent eighteen months. four
Quant funds recovered and most likely now hold twice as much in assets as at their peak in July 2007. five  But that is the peak of the iceberg. Mathematical-based investing methods have been adopted by many active managers and exchange-traded funds under names such as wise beta, factor or style investing. Institutional quant hedge funds have addressed the risk issues that caused two thousand seven losses, but the newer retail products cannot. The hedge funds in August two thousand seven did not have to report losses until the end of the month, six and most investors would have been locked in until the end of the year. seven  ETFs and mutual funds both report and honor redemptions every day.
In 2007, problems began in late June when investors were spooked by credit issues. eight  Investors worried about leverage, and they needed money from their most liquid strategies. Quant equity qualified for both reasons. Funds diminished positions and volatility went up, causing further position reductions. More losses meant more reductions, more volatility and more losses. For reasons still not understood, the process accelerated for three days in August, hit bottom, and bounced back.
Sophisticated quant hedge funds run with hundreds of factors, many unique to the fund and providing diversification. Many newer products are based on the same few well-known factors. Moreover, the big quant funds in two thousand seven were run by people who invented the methods and had many years of successful practice in running them, with true-believer professional investors as clients. Many quant strategies today are run by elementary algorithms, or managed by people without deep quant roots, and held by fickle investors.
Does that mean the next quant equity crash will be more severe and market-moving? Not likely. The sophisticated quant hedge funds have switched their processes with this kind of event in mind. Moreover, retail investors are unlikely to sell en masse due to general market worries. The newer products use less leverage than hedge funds and many are unlevered, meaning there is less amplification of selling pressure.
I think we're more likely to see the next crash in switch roles. Instead of an investor pullback touching off an accelerating loss spiral, a hard-to-explain loss — perhaps in a single fund — could touch off an investor reaction against a large swath of quant funds. Quant is not an asset class, but it is often marketed that way. The crisis may look more like investor funk about money market funds in September 2008. nine  The one similarity is the only victims are likely to be investors in quant funds. Quant equity positions are too liquid to cause other dominoes to fall. ten
Of course, this may not happen. Perhaps by the time some quant fund has a disaster, investors will have grown used to holding them and will not treat all quant strategies as the same. Other types of funds have deepthroated up without taking entire categories with them. Unluckily, quant seems mysterious and dangerous to many people, making them quicker to fear and slower to trust mathematics versus managers with attractive stories but worse-than-random track records.
In the meantime, the solution is education — as it is to so many problems. Quant investing is not a black box and it is not an asset class. It's just doing systematically and cheaply what all good investors attempt to do. If that message can get out, we could go another ten years without a quant crash.
Bloomberg Prophets Professionals suggesting actionable insights on markets, the economy and monetary policy. Contributors may have a stake in the areas they write about.
Disclosure: I served as chief risk officer at AQR Capital Management, a leading quant stiff, during this crisis. Nothing in the article refers specifically to AQR's products or spectacle; it is based entirely on research about quant equity investors in general.
See Cliff Asness, ”The August of our Discontent,” for a technical description or Scott Patterson's ”The Quants” for a more Hollywood version (based on a true story, as the telling goes, but with more car pursues).
Since quant equity funds have equal long and brief positions, they don't thrust overall stock prices either way when they delever. Unlevered funds, including most clever beta funds, hold only long positions, but if investors switch from these funds to equity index funds or other long equity funds, the net effect on stock prices should be minor.
This was not entirely, or perhaps even mainly, a direct result of the crash. Losses in other investments caused investors to pull money from their most liquid strategies, and quant equity is liquid. At diminished size, many smaller funds could not cover immovable costs. Goldman Sachs Global Alpha was a special case and no doubt owes its demise to a number of factors of which the August two thousand seven loss was only one; moreover, it closed four years later with $1.6 billion in assets, more than sufficient to be a profitable fund. However, it was wounded in August two thousand seven and never regained its luster.
Leverage has been diminished, but total positions may be 50 percent larger than at the peak. All these numbers are little more than guesses as there are definitional and empirical issues in measuring them.
Of course funds that valued their investor relations would have had some serious intramonth conversations.
In typical terms, an investor who had passed the initial lock-up period would have had to give notice before the middle of August to get a Sept. Thirty   redemption, so Dec. Thirty one   was the likely next available date.
Including severe problems with two Bear Stearns hedge funds that are sometimes used to mark the beginning of the global financial crisis that would peak in October 2008.
Or, for those with longer memories, short-term bond funds in 1994. Part of the equation is usually a period of good spectacle leading to more investors being pulled in, causing more good spectacle, until it doesn't. The fresh investors do not have years of good comebacks to ballast their thinking; they bought high and because quant was going up, of course they're going to sell when it's going down.
Mutual funds can lightly sell; authorized participants can redeem ETFs back to their constituent shares. Even hundreds of billions of dollars of redemptions over a few weeks should not strain market infrastructure or liquidity.
To contact the author of this story:
To contact the editor responsible for this story:
No comments