On Quant Funds and the Financial Market Meltdown

"For Wall Street's Math Brains, Miscalculations. Complex Formulas Used by 'Quant' Funds Didn't Add Up in Market Downturn," was the title of an article by Frank Ahrens in the August 21, 2007 Washington Post, Here is an updated version of a post I made to my blog about the article. As Ahrens stated:

"Short for 'quantitative equity,' a quant fund is a hedge fund that relies on complex and sophisticated mathematical algorithms to search for anomalies and non-obvious patterns in the markets. These glitches, often too small for the human eye, can present opportunities for short- and long-term trades that yield high-profit returns."

I felt then, and still do, that the article needed rebutting. What follows are excerpts from the article, interspersed with my responses.

Ahrens: "The models replace instinct. They try to turn historical trends into predictive science, using elegant mathematics seemingly above the comprehension of your average 401(k) participant or Wall Street fund manager.

Instead of veteran, market-savvy traders waving fistfuls of sell slips, the elite quant funds employ Nobel nerds with math PhDs, often divorced from the real world. It's not for nothing that they are called "black-box" funds -- opaque to outsiders, the boxes contain investment magic understood by only the wizards who conjured it up."

My response: Why all this mystification of quantitative methods and computer models? It may make for a "sexier" article, but all it really accomplishes is to promote math anxiety and betray your own ignorance. After all, with computer models, you don't get any more out of them than you put in.

Ahrens: "The acknowledged quant king is James Simons, 69, an M.I.T.-trained mathematician with a groundbreaking theory that physicists are using to plumb the mysteries of superstring study and get at the very nature of existence itself. Simons turned his big brain on investing after his math career, founding Renaissance Technologies quant shop. The firm pocketed $1.7 billion in investor fees last year, among the highest in the industry. In return, his clients can reap annual returns of more than 30 percent, according to news reports."

My response: Jim Simons was a first-rate mathematician who published excellent papers, but Ahrens is overstating his influence, which is in line with the hyperbolic nature of his entire article. I have written two articles on Jim Simons: Me and Jim Simons. The Elvis of Hedge Fund Managers. and Me and Jim Simons. The Elvis of Hedge Fund Managers (II)

Ahrens: "As elegant as the models are, they cannot predict unpredictable events, or human panic, some traders say. Further, some say, too many quant funds are full of myopic brainiacs, overly reliant on their tools.

'Most are idiot savants brought to industrial proportion,' Nassim Nicholas Taleb, former quant-jock and best selling contrarian author, said by phone from Scotland, where he is promoting his new book on improbability, 'The Black Swan.'

'They are very smart in front of a textbook but not smart enough to understand very elementary things in reality,' he said.

Taleb believes in monkey-wrench events that shatter the models of the quant-jocks. He says their algorithms don't adequately account for huge, rare anomalies, such as the current surprise credit crunch. Or the Russian credit crisis in 1998 that nearly put the superstar quant fund of the time, Long-Term Capital Management (LTCM), out of business in a matter of days, saved by cash infusion organized by the Federal Reserve."

My response: If there are any" idiot savants" in all this, it is people like Taleb who make a big splash when they "discover" that all is not random in the financial markets and that so-called "tail events" can occur. As for what happened with LTCM in 1998, Taleb should be faulting all the Nobel Laureates in Economics who thought they had a market-neutral model, which was proved otherwise when the Russians defaulted on their bonds. My feeling about economists has always been that they are the modern day equivalent of astrologers. They have their charts and graphs, but who knows?

(to be continued)