Question:

In regard to “What happened to the Quants in August 2007?”

(i) What is the unwind hypothesis and do the authors believe it explains August 2007?
(ii) Do the authors implicate quantitative strategies? If not, who or what is to blame?
(iii) What lessons do the authors offer. In particular, what lessons for the common (beta) factor exposures analyzed in the hedge fund replication paper?

Answers:

(i) The unwind hypothesis

The key idea here is common factor exposure. The unwind started on August 7th and 8th with a “sudden liquidation of one or more sizable market-neutral equity portfolios. Only a sudden liquidation would cause a strategy to lose close to -5% in the absence of any other significant market developments.” Then, the large losses “almost surely would almost surely have spilled over to long/short equity funds as well as to certain quantitative long-only funds.” “Any explicit factors used to construct that portfolio would have generated a loss for other portfolios with the same factor exposures. For example, if the portfolios that were unwound happened to be long low-P/E stocks and short low-dividend-yield stocks, the impact of the unwind will cause low-P/E stocks to decline and low-dividend-yield stocks to rise (albeit temporarily, until the unwind is complete). All other portfolios with these same factor exposures will suer losses during the unwind process as well ....But even more significant is the fact that many of these empirical regularities have been incorporated into non-quantitative equity investment processes, including fundamental “bottom-up” valuation approaches like value/growth characteristics, earnings quality, and financial ratio analysis. Therefore, a sudden liquidation of a quantitative equity market-neutral portfolio could have far broader repercussions, depending on that portfolio’s specific factor exposures.”

Finally, “In the face of the large losses of August 7-8, most of the affected funds (market-neutral, long/short equity, 130/30, and certain long-only funds) would likely have cut their risk prior to Thursday’s open by reducing their exposures or “de-leveraging”, either voluntarily or because they exceeded borrowing and risk limits set by their prime brokers and other creditors. This was both prudent and, unfortunately, disastrous. The unintentionally coordinated efforts of so many equity managers to cut their risks simultaneously led to additional losses on Thursday August 9th.”

(ii) Do the authors implicate quantitative strategies

No, they do not implicate quant strategies: “the events of August 2007 are not particularly relevant to the efficacy of quantitative investing. The losses were more likely the result of a resale liquidation of quantitatively constructed portfolios rather than the specific shortcomings of quantitative methods.”

The authors point to causes only tentatively ("all of our inferences are indirect, tentative, and without the benefit of much hindsight given the recency of these events. We have no inside information about the workings of the many hedge funds...our perspective should be interpreted with some caution and a healthy dose of skepticism"). Their blame is limited to:

* Increased systematic risk and an increased common factor exposure in the hedge fund industry; i.e., “the common factors driving these strategies have now become a significant source of risk”
* A significant decline in liquidity (at least for long/short)

(iii) Lessons

The authors offer four conclusions:

1. It’s not the quants fault. The episode does not implicate the efficacy of quantitative strategies
2. More connectedness. Compared to August 1998 and the demise of LTCM, the degree of connectedness in the financial systems has increased. ("evidence that problems in one corner of the financial system, possibly the sub-prime mortgage and related credit markets, can spill over so directly to a completely unrelated corner: long/short equity strategies.")
3. Registration won’t solve this. Hedge fund registration (a regulatory solution sought by many) does not address these systematic risks. Registration per se will not help individual investors against these threats.
4. This probably means we can replicate. Hedge fund beta “is now a reality.” This conclusion squarely supports the concept of linear clones in the other Andrew Lo paper.