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Caveat Prognosticator

Monday, October 8, 2007

The financial press may have gotten the quant story wrong.

Caveat PrognosticatorThe market volatility of late summer, which included a huge drop in stock prices from August 6th to August 9th, prompted the financial press to look for a scapegoat. Several journalists and commentators settled on quantitative hedge funds, or “quants,” as the culprits. But did the media get it wrong? New research suggests so.

Quant funds are part of the revolution in finance that has taken place over the last 30 years. They employ sophisticated computer models to select long and short trading positions. But the late-summer market turbulence bruised their image. One Wall Street Journal article detailed “How the ‘Quant’ Playbook Failed.” Another reported that “recent gyrations in the stock market have given ‘quantitative’ hedge funds a black eye.” Financial journalists rushed to the business pages and cable chat shows to finger quant funds for triggering a sell-off and creating a snowball effect that drove prices down.

But in the mad dash to blame somebody for the tumult and losses, it’s possible that many in the press goofed.

A new paper from scholars Amir Khandani and Andrew Lo of the Massachusetts Institute of Technology asks, “What Happened to the Quants in August 2007?” The paper is technical and the conclusions tentative (more on that in a moment). But the authors assert that “the quantitative nature of the losing strategies was incidental” to the sell-off on Wall Street, and that “the source of dislocation in long/short equity portfolios seems to lie … in a completely unrelated set of markets and instruments.”

Hedge funds are the Galapagos Islands of the financial world: areas of rapid evolution and dynamic change. Analyzing them calls for humility and skepticism.

Their paper is a model of circumspection and caution. “We wish to emphasize at the outset,” they write, “that these hypotheses are tentative, based solely on indirect evidence, and without the benefit of hindsight given the recency of these events. For these reasons, this paper should be interpreted more like an evolving case study.”

Khandani and Lo also point out that “the relevant hedge-fund managers and investors are not able to disclose their views on what happened in August 2007.” Quant funds make their money by relying on proprietary strategies they develop. Their edge is a secret and they have an obvious interest in keeping it that way. Otherwise, rival market players might replicate their strategies and squeeze out the profit opportunities.

Small wonder that Khandani and Lo come to such tentative conclusions. Too little is still known about what has happened to make definitive pronouncements. For that matter, we are now approaching the 20th anniversary of the 1987 “Black Monday” correction, and market observers still aren’t certain of what exactly caused it (see Matt Rees’s excellent treatment of that story in the current issue of THE AMERICAN).

As for modern hedge funds, there is a lot we still do not know or understand about an important and revolutionary period of financial engineering that is unfolding on Wall Street and in global capital markets. Lo, who is a disciple of Nobel Prize winner Robert C. Merton, compares hedge funds to the Galapagos Islands of the financial world—areas of rapid evolution and dynamic change. Analyzing any rapidly evolving institution or phenomenon calls for humility and skepticism, both of which were missing in the recent haste to point fingers at James Simons, Goldman Sachs, and other prominent players in the quant business.

Nick Schulz is senior editor of THE AMERICAN and writes the “Techno-Ideas” column. He also edits the website and is currently writing a book with Arnold Kling, titled “Economics 2.0,” that will be published by Encounter in 2008.

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