Monday, August 13, 2007

Quant Mechanics

The Statistical Mechanic talks about hard times for Rocket Science, Wall Street style. It seems that the current financial turmoil has hit the "Quants" hard.

Wolfgang:

I would call it the "quant finance crisis" and there certainly is big trouble in several hedge funds and all kinds of quantitative strategies [*]. As somebody mentioned today, "the last 5 days have been the worst for statistical arbitrage strategies in the last 20 years". This is of course the area of finance where mathematicians, econo-physicists (= physicists who could not get a hep job 8-) and many other smart 'rocket scientists' operate. I wrote about them some time ago, "May the new theories and models of risk prevent us all from meeting the black swan...".
Well, of course they did not and so we witness once again the well-known phase transition from investors interested in return on their money, to investors interested only in the return of their money.

Brad DeLong has also addressed the same topic in The Subprime Meltdown Hits Quant Hedge Funds:

If you had asked me where the subprime meltdown was going to hit first, I would never have guessed "heavy-quant hedge funds." Yet so it has:

Blind to Trend, 'Quant' Funds Pay Heavy Price: by Henry Sender and Kate Kelly:
Computers don't always work. That was the lesson so far this month for many so-called quant hedge funds, whose trading is dictated by complex computer programs. The markets' volatility of the past few weeks has taken a toll on many widely known funds for sophisticated investors, notably a once-highflying hedge fund at Wall Street's Goldman Sachs Group Inc. Global Alpha, Goldman's widely known internal hedge fund, is now down about 16% for the year after a choppy July, when its performance fell about 8%, according to people briefed on the matter. The fund, based in New York, manages about $9 billion. The fund's traders in recent days have been selling certain risky positions, according to these people. Early this week, those moves sparked widespread rumors on Wall Street that the entire fund might be shut down. A Goldman spokesman has said the rumors are "categorically untrue."

Campbell & Co., an $11 billion hedge fund that trades in the futures market as well as in stocks and bonds and is completely driven by such computer programs, was down 10% to 12% by the end of July. Quant funds -- "quant" stands for quantitative -- generally operate by building computer models of market behavior and then allowing the computer programs to dictate trading. A recurring characteristic of the recent trouble in financial markets is that many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become. "Our risk models failed to pick up the fact that we were due for a correction," says Keith Campbell, founder of Campbell & Co. "We were highly diversified. It was the perfect negative storm."... He told investors that the losses stemmed from "a unique combination" of factors.... "All [computer-driven] managers say the models make sense and look like they are working," says Bill Johnston, founder of Bayon Capital, an investment fund based in San Francisco that isn't computer-driven. "But then something happens which statistical probability suggests would never happen."... Renaissance Technologies Corp.... is holding up despite the market's downturn.... Other hedge funds declined to disclose to brokers or portfolio managers in charge of so-called funds of hedge funds just how badly wounded they have been by the recent extreme swings...

"Our strategy is fine. We were just hit by a sixteen-standard-deviation event." "Then it didn't happen: the universe isn't old enough for even one sixteen-standard-deviation event to have ever happened."

Tails are fat.


Wolfgang blames us:

[*] Maybe those complicated stories can be reduced to a much simpler story after all; U.S. consumers lived beyond their means for several years, wasting away their savings (in home equity) and are now in too much debt. Many investors were foolish enough to lend them money. But who wants to hear that?

My first question is this: If clever guys can design statistical models designed to fail only in the case of extremely unlikely random events, can some other clever guy arrange for such an unlikely event to happen non-randomly?

Also, I can understand how a bunch of dumb consumers who would really like to own a house could be persuaded to live beyond their means - after all, if the whole country is, why not them? So how did the IQ 150 plus Rocket Scientists manage to get sucked in?