Quant Turmoil and Volatility Harvesting

Some quant funds have had heavy losses (WSJ) just in the past few weeks.  Some so-called market neutral funds have been hit hard according to this MarketWatch article (emphasis mine):

Black Mesa Capital, a hedge-fund firm that uses computer models to track down investment ideas, said that at least one large hedge fund or investment bank is liquidating "massive" trading portfolios, according to a letter the Santa Fe, N.M.-based firm sent to investors Wednesday.

The warning is causing disruptions and triggering big losses among other so-called market-neutral hedge funds, Black Mesa said in its letter, a copy of which was obtained Thursday by MarketWatch. "Clearly, something is amiss in the markets that few in our strategy, if anyone, have experienced before," Black Mesa's managers, Dave DeMers and Jonathan Spring, wrote. DeMers declined to comment Thursday.

The firm's hedge fund, which has about $1.9 billion in long positions and $1.9 billion in short positions, was down roughly 7.5% this month through Aug. 7. Those losses could grow to as much as 10% for August so far,

The article continues:

Two hedge-fund investors who didn't want to be identified said Thursday that the current turmoil is reminiscent of the collapse of Long-Term Capital Management in 1998.

Update: More via Calculated Risk.  More on Goldman Alpha.

Update II: More on the quant fund pain with an in-depth commentary on what it means, and this quote Bear Stearns-esque quote from David Faber/CNBC: "This is the worst 5 days that [quant funds have] seen in the last 20 years.”  Tykhe capital reportedly loses 20% in August alone.

Market neutral strategies are often long a massive pile of stocks and nearly equally short a massive pile of stocks as Black Mesa is (was?), hoping their strategies pick good longs and shorts.  In a downturn like the past couple of weeks, these funds should in theory not even notice it, yet it would appear they are clocking losses equal to or exceeding the market.  Alpha has suddenly turned to magnified beta.

Update III:  A Lehman analyst has a theory what's going on with the quants.  Update IV: the first week with a 2% up and 2% down day since March 2003.

Volatility Harvesting.  Volatility harvesting methods like the Shannon Method that I currently follow for my own investments typically profit from the normal ups and downs of the market, as long as you aren't trying to catch any falling knives.  These methods buy on the way down and sell on the way up.  Since the market peak yesterday afternoon through close today, some very unusual events have occured.  While the approximately 3-4% drop in the markets over that period would normally trigger 4-5 trades, likely all buys, I've seen 18 trades, with sells nearly equalling buys and my portfolio tracking the market.   What this means is that there is a huge amount of turmoil in many of the individual stocks I track, but it's not all down.  This is consistent with a long/short market neutral unwinding described above, and it's the most unusual period I've seen since running this method beginning Summer, 2003.  Perhaps my portfolio is just unusally concentrated in stocks the quants play with.

A New Indicator.  It's a phenomenon that needs it's own indicator, in my opinion.  Call it the "unwinding indicator" or something similar, but there isn't a good indicator to track this phenomenon that I'm aware of.  Certainly volatility measures it indirectly, but it doesn't fully quantify what's going on under the surface and is somewhat tainted by market directional moves.  Perhaps the ratio of the number of 1% days for a market's components vs. the market would capture the turmoil.  High ratios would indicate unwinding, low ratios would indicate levering.  If possible, volume would be incorporated as well.

Update:  Credit Unwinding, and the carry trade unwinding that happened before.

Comments

[brig]

Can't help but wonder if the removal of the uptick rule hasn't messed up the Quant's formuals.

[Alan J]

An interesting observation. Market neutral funds would typically have 1/2 their trades on the short side. Small differences can multiply to the extent they are leveraged. Then again, it could be too many quants/money chasing the same opportunities.

[Johannes Ernharth]

Problem with quants is they are lead by their formulas like bulls with rings in their noses, unable to see the forest from the trees. Fundamental managers watching the correct fundamentals have been faring quite well. What's odd is the quants shorts strategies are failing so badly to cover the long losses, leading one to believe that their assumptions have been terribly off the mark or that leverage was excessive. Low or zero leverage fundamental folks getting the short side right are fine, too.