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What Happened To The Quants In August 2007?


What Happened To The Quants

In August 2007?
Amir E. Khandani† and Andrew W. Loc

During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere—apparently in a completely unrelated set of markets and instruments—suggests that systemic risk in the hedge-fund industry may have increased in recent years.

Some highlights from this paper:

The following week, the financial press surveyed the casualties and reported month-to-date losses ranging from 5% to −30% for some of the most consistently profitable quant funds in the history of the industry.1 David Viniar, Chief Financial Officer of Goldman Sachs argued that "We were seeing things that were 25-standard deviation moves, several days in a row... There have been issues in some of the other quantitative spaces. But nothing like what we saw last week"

The simultaneous increase in the number of long/short equity funds, average assets per fund, and the growth of related strategies like 130/30, imply greater competition and, inevitably, reduced profitability of the strategies employed by such funds. As the total assets in the Long/Short Equity Hedge and Equity Market Neutral categories grow, the average daily return of the contrarian strategy declines, reaching a low of 0.13% in 2006, and where the total assets in these two categories are at an all-time high of over $160 billion at the beginning of 2007.

As these strategies begin to decay, hedge-fund managers have typically employed more leverage so as to maintain the level of expected returns that investors have come to expect. And because many hedge funds rely on leverage, the size of the positions are often considerably larger than the amount of collateral posted to support those positions. Leverage has the effect of a magnifying glass, expanding small profit opportunities into larger ones, but also expanding small losses into larger losses. And when adverse changes in market prices reduce the market value of collateral, credit is withdrawn quickly, and the subsequent sudden liquidation of large positions over short periods of time can lead to widespread financial panic, as in the aftermath of the default of Russian government debt in August 1998.

In this paper, we have argued through indirect means that the events of August 6-10, 2007 may have been the result of a rapid unwinding of one or more large long/short equity portfolios, most likely initially a quantitative equity market-neutral portfolio. This unwind created a cascade effect that ultimately spread more broadly to long/short equity portfolios, 130/30 and other active-extension strategies, and certain long-only portfolios (those based primarily on quantitative stock-selection and systematic portfolio-construction methods). By August 9th, this unwind and de-leveraging process was over, and the affected portfolios and strategies experienced a significant but not complete rebound on the 10th.