A Look Back at the Quantitative Equity Hedge Fund Crisis in 2007

With all the talk about the debt ceiling crisis and possible repercussions on the markets, I was reminded of another, more limited crisis in August 2007.  There was a paper written by Amir Khandani and Andrew Lo the following month.  From August 7th to the 9th, several quantitative long/short equity hedge funds experienced declines of 27%.  On the 10th, these same strategies rose 23.67%.

There are eight theories created to explain the whipsaw nature of the markets.  They are:

• A multi-strategy hedge fund or proprietary trading desk was forced to sell its most liquid assets, equities, to raise capital to meet margin calls, investor redemptions or to reduce portfolio risk
• The first round of selling caused other funds that were long/short hedge, long only or 130/30 to cut their leverage by selling off their portfolios
• After reducing their portfolios' leverage, there was a complete reversal on August 10th
• The losses were short term and suggests that hedge funds were crowded into the same trades or strategies
• Some factors that caused the magnitude of losses:  rapid growth of long/short and 130/30 funds, high levels of leverage used by funds, quantitative models did not account for crowded strategies and panic because of the subprime problems in the credit markets
• Losses incurred by quantitative funds were the result of the sudden liquidation of market neutral fund(s)
• Systemic risk in hedge funds have increased because of number of funds and assets under management, increased correlation among hedge fund indices and the growth of credit-related strategies
• Credit issues could cause new liquidity problems in long/short, global macro and managed futures

The crowded strategies of hedge funds magnified the losses.  Quantitative funds use the same factors such as January effect, reversion to the mean and price momentum for their investment models.  They use the same risk models.  The fund managers are educated in the same academic institutions and have similar thought processes.  When a large number of leveraged funds have the same holdings, there is often a race to sell at the best prices to limit losses.  The manager holding the position at the end would have the largest losses.

In The Quants:  How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It, Scott Patterson writes that the turning point was when Goldman Sachs Group decided to infuse their quantitative funds with capital.