Finance Weblog: When quants failed. - Instituto de Empresa Business School

During the second week of August 2007 some of the most prominent hedge funds suffered huge losses. Among these funds losses abounded within the long/short quant funds category. Goldman´s funds as well as some of Renaissance’s funds were among the victims just to name a few. The first question that rose is how risk neutral fund could have been so badly affected, after all most of the return should not be beta related and systemic risk should be absent. Second question that attracted the attention of analyst is why those quant funds were hit hardest. In a recent paper by Amir Khandanui and Andrew W.Lo entitled “What happened to the quants in august 2007?” These authors present some hypothesis to explain the triggering of the losses and understand the evolving process that ended with some quant funds having lost close to 30 % of their wealth just on the month of August. In order to understand the pattern of gains and losses and given the lack of transparency of hedge funds they replicate a long/short neutral strategy during the second week of August. Main question addressed is the following: What triggered the losses during the 7th and 8th of August for quant funds when others assets returns did not show abnormal return over these two days? The authors hypothesize that these losses were triggered by the liquidation of a multistrategy fund that was forced to reduce their risk all across the board due to losses is some credit strategies. Losses initiated in a credit related fund (which part of this multistrategy hedge fund), induced deleverage on other investments of the fund, among which was reduction of the investments in long/short quant fund. This unwind started on the 7th of August and extended till the 9th. This original movement probably induced further liquidations during these days as the price impact of the original liquidation caused severe losses on other long/short funds. On the 10th of August the long short quant strategies mean reverted making up all the losses of the previous days. However the severe losses suffered from the 7th till the 9th, were much higher than the final reversal.

The unwind hypothesis as triggering point of all subsequent losses in the long/short neutral funds sector is explained by the authors on two grounds: a) the price impact of the initial shock was due to the increasing illiquidity of the long/short neutral strategies and b) this illiquidity was exacerbated by a higher correlation across strategies (systemic risk of hedge funds) that forced a develerage of some of the long short strategies after two day losses.

a. The price impact of the initial liquidation can only be explained because of illiquidity in the long/short neutral sector. This can be explained because of the increasing number of agents within this sector (long short fund, statistical arbitrage funds,130/30 active extension strategies,…) and the high leverage implemented in this strategy. This level of leverage (eight times the resources of the fund) is needed to attain a reasonable level of return in a crowded strategy. However this has made harder to short stocks and a large liquidation could have induced a temporary price impact in the assets within the strategy.

b. This price impact of the initial liquidation could have offered a good opportunity in normal circumstances, however the fact that losses abounded all across different strategies forced a general deleverage when first losses appeared. This is due to the fact that correlation across strategies has become higher in recent years showing a systemic risk in the hedge fund industry.

These two discussed points provide lessons for the future. First, the analysis on the recent turmoil stresses the fact that illiquidity can appear even in a mature industry and second, systemic risk is dormant (but alive) in some strategies that seemed uncorrelated with the general level of markets.

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