Saturday, April 10, 2010

Review: Scott Patterson’s The Quants

In the past twenty years, “quant” hedge funds like Renaissance, Citadel, and AQR each came to manage tens of billions of dollars, consistently beating the market. They did so using mathematical models and fast computers. But with the recent financial crisis, their winning formulas went bad in ways that weren’t supposed to be possible.

Scott Patterson’s The Quants tells this story by following the careers of several quant luminaries: Jim Simons (Renaissance), Ken Griffin (Citadel), Cliff Asness (AQR), Peter Muller (Morgan Stanley’s Process-Driven Trading group), and Boaz Weinstein (Deutsche Bank’s Saba group). They rose to prominence in the 1990s and 2000s, yet they all followed in the footsteps of Ed Thorp, a professor who wrote the original quant playbook Beat the Market in the late 1960s. Thorp went on to succeed with his own quant funds, starting in the mid 1970s. However, he got out of the game in 2002, citing the dramatic increase in the number of new quant funds all plying the same strategies.

Thorp saw that an increasingly crowded field caused everyone to take more risk to maintain their returns. And indeed as the party continued, the use of leverage—borrowing money to make bigger bets—increased. Despite the leverage-fueled implosion of Long Term Capital Management, one of the largest quant funds at the time of its demise in 1998, the quants thought their models were accurate enough to manage the risk of additional leverage. That seemed to be true through the mid-2000s. The leading quants kept winning, even as the market slumped.

A reporter at The Wall Street Journal, Patterson captures the quant heydays with details like Griffin’s Paris wedding, where he rented out the Palace of Versailles. Patterson also illuminates the power shift that was happening out of the spotlight:

By the early 2000s, [Morgan Stanley’s Process-Driven Trading group] had become so successful that it commanded the largest proprietary trading book in Morgan Stanley’s mammoth equities division. Its traders were treated like hothouse flowers, allowed to ditch the standard attire of an investment bank—the bespoke suits, the polished Italian leather shoes, the watch worth more than a minivan. Traditional bankers at Morgan started sharing elevators with slacker nerds in ripped jeans, torn T-shirts, and tennis shoes. Who the hell are these guys? When queried, PDTers would respond vaguely, with a shrug. We do technical stuff, you know, on computers. Quant stuff.

“Whatever,” the banker would say, adjusting his Hermes tie. Little did the banker realize that the nerdy slacker made ten times his bonus the previous year.

Then came August 2007, when everything went wrong. Although the public stock market did not notice, quant hedge funds were feeling, then feeding, the beginning of a financial crisis. When the subprime mortgage market started collapsing, some major hedge funds were caught highly leveraged in subprime. Because of hedge funds’ lack of transparency, it’s still unclear who these funds were or even if they were quant funds. Whoever they were, they were in trouble: They had borrowed much more than they actually owned, and all of it was underwater and sinking fast. They needed to quickly generate cash to pay back the borrowing, but their subprime assets were no longer worth much. Thus, they needed to find the cash elsewhere.

At least one major fund found the cash by liquidating its quant fund’s non-subprime positions—that is, positions that still had value. However, this sell-off tripped the trigger of many other quant funds that had taken similar (non-subprime) positions. Because these other funds were also highly leveraged, their models told them to sell too.

In other words, a large hedge fund, possibly several large hedge funds, was imploding under the weight of toxic subprime assets, taking down the others [who were not necessarily into subprime] in the process, like a massive avalanche started by a single loose boulder. All the leverage that had piled up for years as quant managers crowded into trades that increasingly yielded lower and lower returns—requiring more and more leverage—was coming home to roost.

Patterson follows the various players through the fire, where a daily loss could be $100 million. Into early 2008, some funds had lost more than half their value—a wipe-out that would have been beyond contemplation, until it happened. Patterson dutifully includes appearances by a few outsiders who saw the train wreck coming, such as Nassim Nicholas Taleb. They were only taken seriously after the fact.

The book concludes in 2009, with the various players mostly back on their feet, making money again like before. Although you might infer good or bad from this, the main point is that it just is. The quants were a key part of the financial crisis because they had become a key part of Wall Street. They had become a key part of Wall Street because what they were doing—at least what the most successful of them were doing—worked. When things went bad, the quant world’s (more generally, the hedge-fund world’s) lack of transparency contributed to the financial meltdown. But as Patterson illustrates above, many quant funds were side-swiped by the subprime mess, as opposed to being perpetrators of it.

Thus, it is not a surprise that the previously successful quants returned with the overall market; a few even posted major gains well ahead of the overall market’s recovery.

That said, beyond the big players profiled in the book, The Quants largely ignores the rest of the quant-fund crowd. It also does not address whether the returns across all quant funds were any higher than market averages during the heyday or during the 2007-2008 bust. We’re left to wonder, are the book’s stars just outliers who happen to be using quant strategies, or is there something about quant strategies that has proved—no pun intended—quantitatively better overall?

Quibbles aside, The Quants is a good read, a page-turner almost. It’s not deep technically, even by popular-business standards. Instead, it leans on the big stakes, the big personalities, and the extreme events of the recent financial crisis to document quantdom’s rise and effect on Wall Street.

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