Barron's [subscription required] revealed some scary statistics about this week's carnage. The smartest of the smart are finding that their computer models are telling them to do the wrong things at the moment of maximum peril. As a result, The Goldman Sachs Group's (NYSE: GS) $8 billion Global Alpha hedge fund is down 26% so far this year and the $26 billion Renaissance Institutional Equities Fund -- run by the $1.7 billion (2006 compensation) man, James Simons -- has fallen 8.7% so far this month.
What is going on? The computer models that run these funds don't model what is happening now -- a simultaneous dash to liquidate by all their peers. Statistical factor-based quantitative models -- which weight dozens of valuation, growth, and momentum variables to create long/short portfolios -- have attracted many competitors.
Their models broke in recent weeks as volatility surged, leverage was cut back, heavily shorted stocks went up and statistically cheaper shares cracked. One anonymous manager said "There is this unknown risk, when there are enough people doing what you do, that when some of them have to unwind and they start unwinding -- you are just going to get crushed. And that's not in the model anywhere."
Models that break when markets go haywire are nothing new. This is what happened in 1998 when Long Term Capital Management, a hedge fund run by a Nobel prize winning economist, lost $4.6 billion in in four months and closed in 2000. But with this background, model builders should also have incorporated the market dynamics from previous such periods -- 1987, 1998, 2001, and 2002. All these model failures grew from volatility storms, and after big losses, gave way to forceful rebounds and recoveries in quant efficacy.
The bottom line is that these quant jocks will be tested as they try to cope with the failure of their models, even as investors are clamoring to get out and banks are asking for their money back. Other shoes will drop, but thanks to the lack of hedge fund disclosure requirements, nobody knows the number or magnitude of the dropping shoes.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Goldman Sachs.
Why do we have a weak dollar?
Holiday hiring slow for retailers
Closing Bell: What sell-off? (AIG, ABK, EPR, MBI, JAVA, ORCL, ERTS)
Reader Comments (Page 1 of 1)
8-12-2007 @ 7:45AM
arun said...
When you people talk that hedge funds take their money out..but actually they are using this crash as an opportunity to buy the stocks cheap...
France’s biggest bank BNP Paribas, which has triggered a sharp plunge in the Indian and other global equity markets in the past two days, on Friday purchased shares worth Rs 20.46 crore in a single company here in India. BNP Paribas Arbitrage, a foreign fund promoted by the French banking giant, acquired 1.65 lakh equity shares in Northgate Technologies at Rs 1,240 per share in a bulk deal at the Bombay Stock Exchange. The BSE sensex have witnessed a plunge of 440 points in the past two days, while the stock markets in the US and Europe have also seen sharp decline in the two days, primarily on fresh sub-prime concerns triggered by BNP Paribas’ move on Thursday to suspend withdrawals from three mutual funds. It has freezed withdrawals from three of its mutual funds with assets worth $2.2 billion due to their exposure to the US subprime market.
Here is the link for the full article http://www.stocktips.in/?p=15382
We investors need to be cautious now...