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.
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:
