The myth of exogenous risk and the recent quant problems

Regular readers of my work will know that I am deeply skeptical over the idea of exogenous risk (like a gambler playing roulette, where the behaviour of other players is irrelevant). In Chapter 36 of Behavioural Investing I argue that many aspect of risk are endogenous ( like a gambler playing poker, where the actions of the other plays are integral to the game) to the way in which we invest. The problems experienced by the quant funds in August may help highlight some of these issues.

Now as my post on the 17 August detailed I suspect that leverage had much to do with the problems experienced by the quant funds. As one observation reader commented the hubristic use of excessive leverage is an all too human failing, and has nothing do to with the 'quant' process as such.

Andrew Lo (of MIT) and Amir Khandani have written a fascinating paper on the problems of August (available here ). They use indirect evidence to establish the scale of the issue and the kind of problems to be encountered. They use a very simple contrarian strategy of simply buying yesterdays losers, and selling yesterday's winners on a daily basis. They ignore all the issues surrounding transaction costs and turnover, as this is only an example.

They document several interesting features using this simple strategy. The first is alpha cannibalisation (or alpha decay as they call it). As more and more funds have set up in the quant arena so the return to this strategy has declined from an average daily return of 1.38% in 1995, to a mere 0.13% in 2007.

They show that in order to increase the return back to the level seen in 1998, leverage of around 8-times would have been required. As noted in my original post Goldmans Global Equity Opportunity fund was running 6 times! They also show that this strategy performed exceptionally badly in August. It witnessed several consecutive days in August (nearly 7% over 3 days, a 12 standard deviation event).

In a comparsion between 1998 and 2007, Lo and Khandani show that the big difference between 1998 and 2007 is the lack of spillover in the LTCM crisis. Whilst markets had a turblent time as LTCM problems became widely known in the wake of the Asian and Russian crises, simple quant strategies continued to work.

This hints at one possible (perhaps even probable) cause of August's events. A multi-strategy funds (or prop desk) took a big hit in the mortgage/CDO space, and as a result was forced to scale back on operations across the board, terminating their positions in equity space.

This in turn probably caused other quant funds to hit their limits, and unleashed a vicious spiral of selling, and further selling. The more crowded a trade is, the more likely this outcome becomes.

A survey for the the CFA publication Trends in Quantitative Finance (April 2006) showed that out of 21 firms using quant, 18 used them for return forecasting (with around $2 trillion invested in equities). The most popular factors uncovered were 'reversal' with 86% of those questioned citing it's use. In second place came 'momentum' with 81%, and in third was exogenous factors (such as valuations, earnings quality, capex ect) with 62% of respondents using such methods.

The recent so called 'quant problems' are a timely reminder of the endogenous nature of risk in our markets.