Institutional Investor's Alpha Magazine - March 2008 - (Page 27) Summer Solstice: How the Quants Fell Back to Earth hen quantitative hedge funds trading long-shor t equit y strategies racked up big losses in August, Andrew Lo wasted no time weighing in. Lo, 47, is Harris & Harris Group Professor of Finance at MIT Sloan School of Management, where he directs the Laboratory for Financial Engineering. He is also co-founder of AlphaSimplex Group, a multistrategy quantitative hedge fund fi rm based in MIT’s hometown of Cambridge, Massachusetts, and has a long-standing research interest in the hedge fund industry’s vulnerability to systemic shocks. A month after the blowup, Lo and his student Amir Khandani released the first draft of a paper called “What Happened to the Quants in August 2007?” Their hypothesis: Last summer’s losses resulted from the unwinding of one or more quantitative equity market-neutral portfolios. Because the price impact was so swift and dramatic, the unwinding probably began with a sudden liquidation by a large multistrategy fund or proprietary trading desk, perhaps to cut risk or meet margin calls on a credit portfolio. Most of the damage occurred from August 7 to August 9, when many funds started selling to reduce their risk. By deleveraging, these firms missed the bounce back in equities on August 10. Lo and Khandani had no data from the quant shops themselves, so they created a simulated long-short equity strategy and then compared it against the individual and aggregate performance of hedge funds in the Lipper TASS database. Using their test strategy’s performance as a “microscope,” Lo says, they also compared August 2007 with August 1998, when Greenwich, Connecticut–based LongTerm Capital Management and other fixedincome relative-value hedge funds suffered a similar meltdown. L ike the sequence of event s in 19 9 8, which were triggered when Russia defaulted on its bond payments, last summer’s troubles were precipitated by a credit crunch. But this time around, Lo says, a shock in one area — subprime mortgages and credit portfolios — infected a completely unrelated sector of the market. The events of August 2007 had a big impact on equity prices; those of August 1998 had none at all. (In 1998 the Standard & Poor’s 500 index was up 28.6 percent; last year the S&P was up just 5.5 percent.) “What that tells us is that the hedge fund space is very, very crowded,” Lo says. “The economy is much more sensitive to shocks in the hedge fund sector than ever W before. This is proof positive that systemic risk has increased.” In 1999, Lo launched AlphaSimplex after developing quantitative models as a consultant to institutional and private investors. The firm’s first offering was a U.S. long-short equity fund for Greenwich-based Paloma Partners Management Co. In late 2003, AlphaSimplex opened a global long-short fund to multiple investors. Last September, Paris-based Natixis Global Asset Management acquired the firm, which Lo says he’s not surprised that statistical arbitrage and other quant strategies got slammed last summer. “Quant funds by their nature are going to be invested in mostly liquid strategies, and so when we have massive liquidations, they’re going to be first in line to take their licks,” he explains. To protect themselves, Lo says, quant funds must understand their exposure to future selloffs. That means paying close attention to the relationship between liquidity and their strat- “Systemic risk has increased,” says MIT Sloan School finance professor Andrew Lo. has 20 employees and manages $550 million in assets. Lo has stayed on as chief scientific officer and chairman. Lo’s dual career as an academic and a hedge fund manager grew out of his pioneering research in fields as disparate as statistics and psychology. A partnership with industry, his MIT laboratory receives funding from several investment firms, including Boston’s State Street Global Advisors and Newport Beach, California–based Pacific Investment Management Co., both of which offer absolutereturn strategies. egies’ expected returns. “We can’t forecast with any degree of accuracy when the next LTCM is going to hit,” Lo says. “But we can tell when certain market conditions are ripe for a dislocation and gradually try to adjust our risk exposures to take that into account.” Lo believes that forecasting such disruptions will remain a problem — at least until hedge fund fi rms surrender more-detailed information. “The hope is that if we can get more data for both investors and managers to use, we will be able to avoid this kind of mad rush to the exits in the future,” he says. — N.R. Photo by Chad Batka for Alpha MARCH 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 27
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