"What Happened to the Quants in August 2007?"

Paul Kedrosky (of Infectious Greed fame) points to a a terrific paper by Amir E. Khandaniy and Andrew W. Lo of MIT, “What Happened to the Quants in August 2007?”. I’ll confess that I have only skimmed it, but it looks thoughtful, has all the right caveats (the researchers admit they may not have and can never get the right data), but by looking at the data they can access and building an indicative model, they’ve come up with some plausible theories. And if they are wrong, their arguments might provoke insiders to offer some corrections.

We’ll give some excerpts below, but their most interesting finding is that de facto, hedge fund strategies have become more correlated. This is precisely what you don’t want to see if you are a hedge fund investor; you are supposedly paying for alpha, meaning manager ability to beat the market, rather than what amounts to a general hedge fund return, which Khandaniy and Lo call “hedge fund beta.” (And if you are an institutional investor, you also think you are paying for a particular hedge fund style, such as distressed debt or global macro, and they in turn are supposed to have distinctive profiles that are usefully not highly correlated with your other holdings).

A troubling factoid is that the Fed had taken note of increased correlation of hedge fund returns back in May and attributed it to low volatility, which means in effect they dismissed any risk. Khandaniy and Lo instead note the use of much higher leverage as competition has made it harder to achieve target returns (which means credit risks are more tightly linked, which in turn means that adverse events can force investors in different strategies to the exits at the same time, thus producing correlated results in seeming uncorrelated investment approaches).

But it’s been an open secret for some time that hedge funds may not really be delivering alpha after all. As we noted in an earlier post:

The rationale for hedge funds’ eyepopping fees is that investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperfrom the market are rare indeed….

Targeting a particular risk/return tradeoff isn’t an alpha proposition at all. It is instead “synthetic beta,” (or “alternative beta”). And synthetic beta can be produced comparatively cheaply.

A 2005 survey (http://www.edhec-risk.com/edhec_publications/RISKArticle.2005-08-10.3923/view, free subscription required) found that 70% of the investors recognized the role of alternative beta in overall hedge fund results. But this knowledge hasn’t yet translated into a recognition that they are overpaying.

From Khandaniy and Lo:

From these empirical results, we have developed the following tentative hypotheses about
August 2007:
1. The losses to quant funds during the second week of August 2007 were initiated by the temporary price impact resulting from a large and rapid \unwinding” of one or more quantitative equity market-neutral portfolios. The speed and magnitude of the price impact suggests that the unwind was likely the result of a sudden liquidation of a multi-strategy fund or proprietary-trading desk, perhaps in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions, or a discrete change in business lines.

2. The price impact of the unwind on August 7{8 caused a number of other types of equity funds|long/short, 130/30, and long-only|to cut their risk exposures or “de-leverage”, exacerbating the losses of many of these funds on August 8th and 9th.

3. The majority of the unwind and de-leveraging occurred on August 7-9, after which the losses stopped and a significant|but not complete|reversal occurred on the 10th.

4. This price-impact pattern suggests that the losses were the short-term side-effects of a sudden (and probably forced) liquidation on August 7{8, not a fundamental or permanent breakdown in the underlying economic drivers of long/short equity strategies. However, the coordinated losses do imply a growing common component in this hedge-
fund sector.

5. Likely factors contributing to the magnitude of the losses of this apparent unwind were: (a) the enormous growth in assets devoted to long/short equity strategies over the past decade and, more recently, to various 130/30 and active-extension strategies; (b) the systematic decline in the profitability of quantitative equity market-neutral strategies, due to increasing competition, technological advances, and institutional and environmental changes such as decimalization, the decline in retail order flow, and the decline in equity-market volatility; (c) the increased leverage needed to maintain the levels of expected returns required by hedge-fund investors in the face of lower profitability; (d) the historical liquidity of U.S. equity markets and the general lack of awareness (at least prior to August 6, 2007) of just how crowded the long/short equity category had become; and (e) the unknown size and timing of new sub-prime- mortgage-related problems in credit markets, which created a climate of fear and panic, heightening the risk sensitivities of managers and investors across all markets and style

6. The fact that quantitative funds were singled out during the week of August 6, 2007 has less to do with any specific failure of quantitative methods than the apparent sudden liquidation of one or more large quantitative equity market-neutral portfolios. This rapid unwind impacted all equity market-neutral funds, and such funds are, by necessity, quantitatively managed (it is virtually impossible to manage a market-neutral equity fund of more than 100 securities using pure discretion and human judgment, and the funds that were affected typically hold over 1,000 securities on any given day).

7. The differences between the behavior of our test strategy in August 2007 and August 1998, the increase in the number of funds and the average assets under management per fund in the TASS hedge-fund database, the increase in average absolute correlations among the CS/Tremont hedge-fund indexes, and the growth of credit-related strategies among hedge funds and proprietary trading desks suggest that systemic risk in the hedge-fund industry may have increased in recent years.

8. The ongoing problems in the sub-prime mortgage and credit sectors may trigger additional liquidity shocks in the more liquid hedge-fund style categories such as long/short equity, global macro, and managed futures. However, the severity of the impact to long/short equity strategies is likely to be muted in the near future given that market participants now have more information regarding the size of this sector and the potential price-impact of another resale liquidation of a long/short equity portfolio.

More juicy stuff:

By comparing August 2007 to August 1998, in Section 5 we observe that, despite the many similarities between the two periods, there is one significant difference that may be cause for great concern regarding the current level of systemic risk in the hedge-fund industry|our microscope revealed not a single sign of stress in August 1998, but has shown systematic
deterioration year by year since then until the outsized losses in August 2007. We attempt to trace the origins of this striking difference to various sources. In particular, in Section 6, we consider the near-exponential growth of assets and funds in the long/short equity category, the secular decline in the expected rate of return of our test strategy over the years, and the
increases in leverage that these two facts imply.

With the appropriate leverage assumptions in hand, we are able to produce a more realistic simulation of the test strategy’s performance in August 2007, and in Section 7 we lay out our “unwind hypothesis”. This hypothesis relies on the assumption that long/short equity strategies are less liquid than market participants anticipated, and in Section 8 we estimate the illiquidity exposure of long/short equity funds in the TASS database. We find evidence that over the past two years, even this highly liquid sector of the hedge-fund industry has become less liquid. And in Section 9, we investigate the changes in simple correlations across broad-based hedge-fund indexes over time and find that the hedge-fund industry is a more “highly connected” network now than ever before.

After arguing that their work says that the tsuris of August were not an indictment of quant strategies per se, the authors present some additional conclusions:

Second, the contrast between August 1998 and August 2007 has important ramifications for the connectedness of the global nancial system. In August 1998, default of Russian government debt caused a flight to quality that ultimately resulted in the demise of LTCM and many other fixed-income arbitrage funds. This series of events caught even the most experienced traders by surprise because of the unrelated nature of Russian government debt and the broadly diversified portfolios of some of the most successful fixed-income arbitrage funds. Similarly, the events of August 2007 caught even the most experienced quantitative managers by surprise.

But August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the nancial system|possibly the sub-prime mortgage and related credit markets|can spill over so directly to a completely unrelated corner: long/short equity strategies. This is the kind of “shortcut” described in the theory of mathematical networks that generates the “small-world phenomenon” of Watts (1999) in which a small random shock in one part of the network can rapidly propagate throughout the entire network.

The third implication of August 2007 is that the notion of “hedge-fund beta” described in Hasanhodzic and Lo (2007) is now a reality. The fact that the entire class of long/short equity strategies moved together so tightly during August 2007 implies the existence of certain common factors within that class. Although more research is needed to identify those
factors (e.g., liquidity, volatility, cash flow/price, etc.), there should be little doubt now about
their existence. This is reminiscent of the evolution of the long-only index-fund industry, which emerged organically through the realization by most institutional investors that they were all invested in very similar portfolios, and that a significant fraction of the expected returns of such portfolios could be achieved passively and, consequently, more cheaply.

Of course, hedge-fund beta replication technology is still in its infancy and largely untested, but
the intellectual framework is well-developed and a few prominent broker/dealers and asset-management firms are now offering the rst generation of these products. To the extent that the demand for long/short equity strategies continues to grow, the increasing size of assets devoted to such endeavors will create its own common factors that can be measured,
benchmarked, managed, and, ultimately, passively replicated.

Finally, the events of August 2007 have some useful implications for regulatory reform in the hedge-fund sector. Recent debate among regulators and legislators have centered around the registration of hedge funds under the Investment Advisers Act of 1940. While there may be compelling arguments for registering hedge funds, these arguments are generally
focused on investor protection which is, indeed, the main impetus behind the ’40 Act.

But investor protection is not necessarily related to systemic risk, and the best ways to deal with the former may not be optimal for the latter. In fact, registration does not address the systemic risks that hedge funds pose to the global financial system, and currently no regulatory body has a mandate to monitor, much less manage, such risks in the hedge-fund
sector. Given the role that hedge funds have begun to play in nancial markets|namely, active providers of liquidity and credit|they impose externalities on the economy that are no longer negligible.

In this respect, hedge funds are becoming more like banks, and the reason that the banking industry is so highly regulated is precisely because of the enormous social externalities banks generate when they succeed, and when they fail. Unlike banks, hedge funds can decide to withdraw liquidity at a moment’s notice, and while this may be acceptable if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the nancial system if it occurs at the wrong time and in the wrong sector.

This observation should not be taken as a criticism of the hedge-fund industry. On the contrary, hedge funds have created tremendous economic and social benefits by supplying liquidity, engaging in price discovery, improving risk transfer, and uncovering non-traditional sources of expected return. If hedge funds have increased systemic risk, the relevant question
is “by how much?” and “do the benefts outweigh the risks?”. No one would argue that the optimal level of systemic risk for the global financial system is zero. But then what is optimal, or acceptable?

The first step to addressing this issue is to develop a better understanding of the likelihood and proximate causes of systemic risk; one cannot manage that which one cannot measure. The proposal by Getmansky, Lo, and Mei (2004) to establish a National Transportation Safety Board-like organization for capital markets is one possible starting point. By establishing a dedicated and experienced team of forensic accountants, lawyers, and financial engineers to monitor various aspects of systemic risk in the financial sector, and by studying every financial blow-up and developing guidelines for improving our methods and models, a Capital Markets Safety Board may be a more direct way to deal with the systemic
risks of the hedge-fund industry than registration.

In the aftermath of the Second World War, a group of socially minded physicists joined to form the Bulletin of Atomic Scientists to raise public awareness of the potential for nuclear holocaust. To illustrate their current assessment of the appropriate state of alarm, they published a “Doomsday Clock” indicating how close we are to “midnight”, i.e., nuclear
annihilation. Originally set at 7 minutes to midnight in 1947, the clock has changed from time to time as we have moved closer to (2 minutes to midnight in 1953) or farther from (17 minutes to midnight in 1993) the brink of nuclear disaster. If we were to develop a Doomsday Clock for the hedge-fund industry’s impact on the global nancial system, calibrated to 5
minutes to midnight in August 1998, and 15 minutes to midnight in January 1999, then our current outlook for the state of systemic risk in the hedge-fund industry is about 11:51pm.

For the moment, markets seem to have stabilized, but the clock is ticking…

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