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.

Active Extension Funds: Mutual Funds with Leverage

One of the main types of institutional investors is the mutual fund.  In the last five years, a new type of fund has been created called 130/30 active extension.  A mutual fund (a.k.a. long only) can only buy securities.  The 130/30 fund can short securities in the same manner as a hedge fund.  However, leverage is restricted to 30% of the portfolio value.  There are other funds that have more or less leverage and are known as 150/50, 140/40 or 120/20 funds.

The proceeds from the short sales can be re-invested as additional investments.  The fund still has overall 100% exposure to the markets.  This allows investment management firms to capitalize on all their research.  If a firm's analysts and portfolio managers cover a stock and determine that it's price will go down, then it can act on that knowledge by shorting the stock.  In a mutual fund, they would sell the position or not buy it.

130/30 were created by mutual fund complexes as a reaction to the growth of hedge funds after the technology bubble.  At that time, absolute return vehicles were growing rapidly and mutual funds had lost the trust of the investors.  Hedge funds were increasingly taking away the best talent from mutual funds and this was seen as another way to combat the brain drain.  130/30 funds would command higher fees than long only funds and contribute to their bottom line.

An issue would be the availability of stocks to short.  Do the mutual fund managers know how to short stocks from an operational point of view?  Do they have the relationships with Prime Brokers' stock loan desks that hedge fund managers do?  One does not call a stock loan representative out of the blue and ask to borrow securities.

Later on, we will compare the strategies and results of mutual funds, 130/30 funds, long/short hedge funds and equity market neutral hedge funds.