What Happened To The Quants? Flashcards
- What question(s) are the researchers trying to answer?
From August 6th through August 9th 2007, many long-term successful equity hedge funds reported record losses. The losses seemed to be concentrated among quantitatively managed equity market-neutral or statistical arbitrage hedge funds - “quant” funds. This paper explores possible reasons for this phenomenon.
- What prior evidence is there from other studies in relation to this question?
This updates Khandani and Lo (2007) where the same authors analyzed the Quant Meltdown and proposed the “Unwind Hypothesis”– the losses were due to forced liquidation of one or more large equity market-neutral portfolios and the subsequent price impact caused other similarly constructed portfolios to experience losses. These losses caused other funds to deleverage their portfolios, yielding additional price impact that led to further losses, more deleveraging, and so on.
The research departments of major investment banks have also produced analyses - Goldman Sachs Asset Management (2007) citing simultaneous deleveraging and a lack of liquidity while Rothman (2007) attribute the simultaneous bad performance to “a liquidity-based deleveraging phenomena”.
Brunnermeier (2008) demonstrates how “network effects” and “fire-sale externalities” can generate “liquidity spirals” from relatively small shocks. The end result for leveraged hedge funds: correlated selling pressure and a contagious downward spiral in prices.
- What methodology, data sample and time period do they use?
The authors simulate the performance of typical mean-reversion and valuation-factor-based long/short equity portfolios from July to September 2007 to measure market liquidity and price impact before, during and after the Quant Meltdown.
They use annual and quarterly balance-sheet information from S&P’s Compustat database to create various valuation factors for the members of the S&P composite 1500 index in 2007 and they use Trades and Quotes (TAQ) data from the NYSE to construct returns for 5-minute intervals within each trading day.
They focus on 5 of the most cited quantitative equity valuation factors – Book-to-market, Earnings-to-price, cashflow-to-market, Price Momentum and Earnings Momentum. They construct the intra-day returns of long/short market-neutral portfolios based on these factors.
- What are their key findings?
The authors find evidence of a first round of deleveraging on August 1st and a 2nd sustained deleveraging on August 6th and 7th. They find indirect evidence of the unwinding of factor-based portfolios starting in July and continuing into August 2007. It’s hypothesized that the losses originated from the forced liquidation of one or more large equity market-neutral portfolios.
Their simulated high-frequency (5-minute) mean-reversion strategy finds evidence of a sharp temporary decline in market liquidity in the second week of August. The authors conjecture that part of the losses stemmed from a reduction in liquidity, most likely from certain hedge funds engaged in high-frequency market-making activities. Unlike designated market-makers that are required to provide liquidity, hedge funds have no such obligation. The authors conjecture these traders may have left the market during the second week of August, either because of losses sustained during the start of the week, or because they were forced to reduce their exposures due to unrelated losses.
- What contribution do they make to the literature and what is different relative to prior evidence?
The paper concludes that systemic risk in the hedge-fund industry has increased significantly in recent years (supported by Chan et al., 2007), at least in the quantitative funds, many of which closely resemble each other.
As with LTCM and other fixed-income arbitrage funds in August 1998, and the 1987 market crash (Black Monday), the feedback loop of coordinated forced liquidations leading to deterioration of collateral value and causing further losses by triggering stop/loss and deleveraging policies took hold during the second week of August 2007. Interestingly, the quant strategies again suffered during summer 2008, this time the alleged cause was the short selling restrictions that the government implemented in an attempt to prop up the vulnerable companies.
This paper highlights additional risks faced by investors in equity funds, namely “tail risk” due to occasional liquidations and de-leveraging that may be motivated by events completely unrelated to equity markets.
