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The 11/9 Quant Crash.

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Quants are regarded as being among the elite on the markets, but they are far from being infallible. Especially in years like 2020, when extremely unlikely events occur several times; they have had to take heavy losses.

Once in all eternity

9/11 is a date from 2001 that many people think back to with fear and trepidation: the terrorist attacks in the USA. The reverse order, 11/9, on the other hand, goes down in history as a day of liberating news. For on 9 November an effective corona vaccine was announced. The markets celebrated the news with a price jump - but not everyone was happy about the rapid turnaround, especially not the quants.

An article on Bloomberg put it in a nutshell: A quant shock that ‘never could happen’ hits Wall Street models“.[1] Jon Quigley, CIO of Great Lakes Advisors, has calculated that under the theoretical assumption of a normal distribution, the crash of the momentum factor on this day should occur only once in - hold on - 5,944,505,312,905,660,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000 days.

We have not done the math. But even a power of ten more or less would be irrelevant. Because what is decisive is the sheer unimaginable magnitude. By way of comparison, our universe is about 13.8 billion years old, which is only about 5,000,000,000,000 days.

Although we cannot assume a normal distribution on the markets, even assuming much more frequent extreme values with pronounced fat tails, the sudden rotation was a huge shock for any risk model. While momentum stocks suddenly crashed, small caps and value stocks exploded simultaneously.

The event is reminiscent of an apprehension that is driving many an expert: All the money invested in quant strategies could cause a crowding - and an unexpected trigger event could then trigger a devastating crash. Quants have known for a long time that this scenario is by no means an empty promise. Especially those who were already in business in August 2007.

quant hedge funds assets
Figure 1) Quant hedge fund assets
The chart shows the development of assets managed by Quant Hedge Funds over the last five years. The data are taken from the proprietary database of Aurum Funds. In contrast, the leading database of Hedge Fund Research, which is not accessible free of charge, shows an overall higher level of assets under management.
Source: Aurum Funds

The Quant Meltdown

6 August 2007 was no ordinary start of the week. Within a few days, one of the most turbulent phases the quant range has ever experienced was to take place. After many years of attractive returns, not only did new investors keep pushing into quantitative strategies, but comparatively high leverage was also used. This made the system inherently unstable.

All that was needed was a trigger to cause the crash. As George Mussalli writes in "Quant Meltdown: 10 Years Later", this happened when the then subprime market first crumbled. After years of declining credit quality, declining lending standards and considerable inflows of funds, the wind shifted, so that suddenly and simultaneously liquidity was in demand among the major counterparties - and this was especially true in the quant sector. In the short term, so many positions were closed out that unintended domino effects occurred: The volatility of factor yields increased fivefold in a very short time, and otherwise uncorrelated factors suddenly ran synchronously - a disaster for risk models. [2]

Gary Chropuvka, the current co-head of quant strategies at Goldman Sachs Asset Management, told the Financial Times about his experience at the time:

All this worked academically, and for a long time it worked in practice, and then all of a sudden you have this horrible event. It was the most humbling experience of our lives.
Wigglesworth, R. (2020), Goldman Sachs’ lessons from the ‘quant quake’

Around the world, during the week of chaos, Quants had to quickly reduce their risks by liquidating additional positions. After a very short time, this led to sometimes extreme price movements of individual stocks. In the end, fundamental investors were called upon to recognise the opportunities in particularly shaken stocks and stabilise prices to their own advantage. At the end of the turbulent week, the spectre was over and many of the affected shares traded again where they were at the beginning of the week. Almost as if nothing had happened at all.

The paper also mentions concrete factors that contributed to the crash at the time: "There were many quant teams around the world that developed models independently of each other - but they were suddenly strongly correlated and experienced high drawdowns at the same time. The key catalysts for this were the similar mindset of using factor-based variables in the development of strategies and the same methodology for portfolio construction and risk management. [2]

Can history repeat itself?

Although quants today use lower levers overall than in 2007, they manage more capital at the same time. In addition, ready-made data sets and models enable even less experienced market participants to compete in the quant market. Big data and machine learning are used as a matter of course and are rarely questioned, but ultimately a variety of algorithms could be applied to a limited number of well-marketed data sets and learn similar patterns. Moreover, quantitative approaches are now also included in many standard investments, so a crash could have far-reaching consequences.

But the latter point is also a counter-argument: the current breadth of concepts and strategies used should increase the inherent stability of the system. In addition, enough quants have (hopefully) learned sustainably from the crash and are primarily concerned with finding out what can go wrong, rather than with teasing out the maximum return.

Figure 2) Quant sub-strategies performance 2020
The performance of the individual quant sub-strategies in 2020 to date is shown, based on the proprietary database of Aurum Funds. Status: 25.11.2020.
Source: Aurum Funds

One thing is certain, however: Quantum performance has recently been far worse than until 2007, when the crash happened. This is because quants have to deal with further challenges, in particular faster changes in market regimes, of which 2020 was the best example. Well-known quant pioneers such as Renaissance Technologies, Two Sigma and AQR Capital are therefore deep in the red for the year.

Conclusion

Events that statistically should happen at most once in an eternity occur much more frequently on the markets. At the same time, these scenarios are difficult to quantify. For this reason, quantum business is and will remain a constant challenge even for the absolute elite of market participants with the best technical skills and largest deals.

Credits

[1] Lee, J. (2020), Quant Shock That ‘Never Could Happen’ Hits Wall Street Models, Bloomberg, https://www.bloomberg.com/news/articles/2020-11-13/quant-shock-that-never-could-happen-hits-wall-street-models, access from 18.11.2020
[2] Mussalli, G. (2018), Quant Meltdown: 10 Years Later, PanAgora Asset Management
[3] Wigglesworth, R. (2020), Goldman Sachs’ lessons from the ‘quant quake’, https://www.ft.com/content/fdfd5e78-0283-11e7-aa5b-6bb07f5c8e12, access from 25.11.2020

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