As the "worse than LTCM" credit crunch continues, new details about the quant hedge fund bloodbath that I discussed in the previous post have emerged. Ironically, the LTCM "trio" recently reunited to form a quant fund. First, a theory of what's going on (emphasis mine):
To stem possible losses, the managers sought to scale back their leverage. But selling the illiquid credit products risks uncovering even deeper losses as the credit positions were marked-to-market instead of marked-to-model, so these managers likely de-levered by selling more liquid assets—namely, US stocks.
“As these managers unwound significant factor based portfolios, these factors started to behave in unexpected and potentially troubling ways. Short names started to rally and long names started to fall as these trades started to hit the market. As most quantitative managers use similar quantitative factors, this abnormal factor phenomenon was not confined to a few funds. Rather, a large number of quantitative managers have seen their models begin to behave in unexpected ways. Again, it is no longer only the multi-strategy managers, but now pure quantitative equity managers who have started to see their portfolios ‘misbehave,’ both U.S. domestic and global fund managers,” explains Lehman Brothers analyst Matthew Rothman in a memorandum published today.
Now rumors are flying (via Scurvon Investing), including that Super Quant DE Shaw is down (update) and Jim Simons' fund is affected; and SAC Capital is "running algorithms in reverse" to profit. More rumors: a second Goldman Sachs fund is unwinding. Meanwhile, confusion reigns. Update: yet more rumors.
Tykhe Capital (founded by DE Shaw refugees) is apparently down 20% in August alone. (Update: Tykhe goes on record to say losses are between 17% and 31% in August). Black Mesa is (was) apparently largely in cash now sitting on the sidelines, afraid of a spiral of 'me-too' liquidations.
I have several friends who manage quantitative portfolios across a range of asset classes, and they have pretty much *all* been having a very difficult time over the past few weeks as the subprime mortgage crisis provokes a crisis of leverage and in turn provokes a liquidity crisis which then provokes an asset crisis.
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The remarkable thing about the present situation is how small the real trouble in the subprime market sector really is, and yet how large an effect it is having.
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The problem is - what to do when there is a major contraction of liquidity and computers in charge of substantial sums need to sell and cover positions. If the quantitative models are similar enough, then the computers from a number of funds are all likely to be instructing traders to be buying and selling the same sets of securities.
I suppose the good news is that during a "quant fund crisis," stocks are likely being bought and short covered in equal amounts. (Update: even some shorts are losing money). A market neutral hedge fund unwind would be expected to create a relatively market neutral but volatile crash. Perhaps it's already over. Then again, one wonders: who's next? For all the hoopla and hysteria and the hedge fund implode-o-meter (via Prudent Investor), this still isn't even a 10% correction in stocks. Perhaps today will tell the tale:
Russell is intensely jumpy. But Thursday night he wrote that the Dow Theory sell signal had not been confirmed: "The good news: the July lows are still intact and the new lows are contracting. The bad news Selling Pressure is rising to new highs, and an increasing number of people want "OUT" of this market. Tomorrow is Friday, and by tomorrow's close we'll see how many traders are willing to hold stocks over the weekend. Fridays are always significant in rotten markets."
Update: "Perfect Storm" for quant funds. FINTAG is on top of the news.
Mahalanobis has more on the ins and outs of stat arb.
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