In quant models are the seeds of their own demise.
Oliver Wendell Holmes’ 1858 poem “The Deacon’s Masterpiece”1 describes a perfected one-horse “shay,” a highly engineered carriage designed so that the failure of a single part could not cause an untimely breakdown. By eliminating the weakest links, the carriage performs flawlessly, at first. But the shay does not have a happy ending. It suddenly disintegrates with all the parts failing at once, leaving its rider dazed atop a pile of rubble. Holmes—the father of the eminent U.S. Supreme Court Justice—mocked the pseudo-scientific efforts of the overeducated Deacons of his day to engineer impractical structures.
In our domain, the Deacons are quants (financial engineers) and their Masterpiece is an overly complex quantitative investment strategy. The second week in August marks the four-year anniversary of the quant meltdown of 2007. While the events of 2008, including nationalization of Fannie Mae and Freddie Mac, the failure of Lehman, the bailout of AIG, creation of TARP, etc., have rightly received more scrutiny, August 2007 foreshadowed the global financial crisis and deserves more attention by today’s investors. Analyzing the underlying causes of the quant meltdown helps reveal the perils of complex quantitative strategies and highlights the difference between transparent and rules-based alternative beta strategies such as the Fundamental Index® methodology and newer optimized approaches.
The Quant Meltdown
During the week of August 6, 2007, many large and previously successful hedge funds were forced to de-lever their portfolios and liquidate commonly held securities, resulting in simultaneous drawdowns of 30%, 50%, or worse. To make matters worse, these investments had been sold as risk-controlled and uncorrelated to the market. Khandani and Lo concluded that a “… deadly feedback loop of coordinated forced liquidations leading to deterioration of collateral value took hold during the second week of August 2007, ultimately resulting in the collapse of a number of quantitative equity market-neutral managers, and double-digit losses for many others.”2 Quantitatively managed enhanced index funds experienced similar simultaneous traumas, though the magnitude of losses was lower due to the lack of leverage.
None could have forecast the precise timing of the sudden liquidation of a large trading desk that catalyzed the quant meltdown.3 But should we have been surprised that those funds failed catastrophically? After all, the quant funds of 2007 shared the same structural flaws as the highly engineered financial trading strategies that caused the stock market crash in 1987 and the implosion of Long-Term Capital Management in 1998.4