Understanding Quants' Hazard
As investors consider riskier assets, it may be useful to recall a lesson from
three years ago. The following parable is from an August 2007 newsletter sent to
clients by Jon Sundt, president and chief executive of Altegris Investments, an
allocator to hedge funds and commodity trading advisors.
The example was inspired by the steep losses suffered by quantitative traders in
August 2007. It is from real experience, but Mr. Sundt used fictional names for
the two funds he compared, PhD Fund and Plain Vanilla Fund.
Both funds are market neutral and go long and short US equities. Both have
stellar track records, low correlation to the S&P 500 and reasonable performance
in up and down markets
By 2007, low volatility had lulled many quant shops into a false sense of
security. The lack of any recent blowups or spikes in volatility made them feel
immune to market jolts. At the same time, quantitative models were picking up
nickels where they formerly picked up quarters. Because the models would need to
pick up more nickels to make the same amount of money, many turned to leverage
The PhD Fund had run its models over the past five years and made a killing. Its
managers were rich. They had found that because of the low volatility in the
market and the low correlation within their market-neutral system, they could
leverage their fund.
So they decided to lever eight to one. For every $1 million the Fund put
forward, it borrowed enough to have $4 million for its long book and $4 million
for its short book, staying with the "market neutral" label.
This was genius! The PhD Fund amplified returns, all the while keeping its
market neutral hat on. It had $1 billion under management before leverage. With
leverage, its assets were $8 billion. Its net exposure was zero ($4 million long
plus $4 million short), but its gross exposure was 8x.
For comparison, consider the Plain Vanilla Long Short Fund, with around $400
million under management. It has an experienced research team that evaluates
fundamental measures of a company's stock (bottom-up research) as well as
overall industry trends (top-down research). The team buys what they believe are
undervalued stocks and sells what they believe are overvalued stocks.
The Vanilla Fund's team trade 50 positions long and 50 positions short. They
keep their book market neutral, so their net exposure is zero. They do this by
using the regular margin available for many brokerage accounts. The Vanilla Fund
borrows $1 million for every $1 million dollar invested, meaning it uses $1
million to go long and $1 million to go short, for a gross leverage of 2x. With
leverage, the Vanilla Fund has $800 million under management.
The Vanilla Fund and the PhD Fund both have zero net exposures...for every dollar
long they have a dollar short. Combine this with their performance, and they
look pretty similar. But that is a wrong perception.
The difference is seen by looking at the funds' gross exposure. Here the
differential is huge: 200% for the Vanilla Fund compared to 800% for the PhD
Fund (chart). Gross exposure shows just how leveraged these funds are: 2x versus
During a few days in August 2007, there was an extreme event in the stock
market. In particular, the stocks bought vs. short sold by quant funds went
through a sharp reversal. Because many funds had similar positions, they drove
the market down as they tried to liquidate holdings.
The PhD Fund suffered a 4% loss on the longs and a 4% loss on the shorts. But
that was before the leverage. Because of the leverage, you have to multiply it
by eight, for a 32% loss! The Vanilla Fund also lost money that month, but less.
The moral: Net exposure can be misleading. One has to pay attention to gross