'The Physics of Wall Street': The Most Arrogant Book in the World? Part 12

By Aaron Brown  MAR 04, 2013 10:30 AM

The quant equity crisis of August 2007.

 


Editor's note: The following column is the 12th part of an ongoing series of articles by Aaron Brown examining the claims made in The Physics of Wall Street: A Brief History of Predicting the Unpredictable, a new book by James Owen Weatherall. Click here to read Part 1.

Physicist James Weatherall is the author of The Physics of Wall Street, a book that tries to explain modern finance through the lens of physics. He fails spectacularly, mostly because he was too arrogant to learn anything about the field. He created something of value, however, because his errors are so clearly stated they provide excellent jumping off points to explain how things really work.

Weatherall begins with a search for the greatest investor in the world, described in Part 10 and Part 11. Next he describes the quant equity crash of August 6-8, 2007. This is clearly based on a sloppy reading of Scott Patterson’s The Quants. The Physics of Wall Street contains a feverishly exaggerated nightmare account of that event, extending to all quant strategies and all asset classes all over the world. It literally invokes ghosts and “the madness of men” (a quote from Isaac Newton). None of the quants has “any idea what was going on.” They are desperate. “Something had gone terribly, terribly wrong.” At the peak of the crisis, he hyperventilates, “millions of dollars started flying out the door.”

At this point any financially literate person will burst out laughing, as when Dr. Evil in the first Austin Powers movie demands ransom of “one... MILLION... dollars!” and number two mentions that “Virtucon alone makes 9 billion dollars a year.” Isaac Asimov made a similar point in scientific terms in a collection of essays titled Only a Trillion. One million dollars is something between 0.001% and 0.01% of the assets that were invested in quant equity in August 2007 (the exact amount depends on how narrowly or broadly you define the strategy). More than a million dollars flies in or out the door in an average hour; it takes a lot more than that to cause a historic three-day crash.

The truth is less thrilling than the account in the book. The crisis affected only a single quant strategy: long-short equity. These funds buy some stocks and short others in carefully optimized portfolios that should be immune to changes not just in the level of the stock market, but industry news, country news, weather, interest rates, currency exchange rates, commodity prices, or any other systematic factor. Because these portfolios are so carefully balanced, they don’t move up or down a lot.

Because long-short equity  funds have low volatility and are in a highly liquid asset class, they are relatively safe to lever. Most people lever them between three and six times. Leverage has well-known risks and costs; these are carefully balanced against the additional profit. One consequence of having leverage is you must reduce your positions in response to losses, refusing to do that can lead to blowing up. Cutting your positions after losses and restoring them after gains costs money, the expected amount can be calculated, and charged against the increase in expected profits from larger positions.

Everyone in these strategies knows that there will be times when money is flowing out, positions will be moving against you, and you will have to pay a cost to reduce positions. Everyone is also aware of the self-reinforcing aspect of this; the more people reduce positions, the bigger the losses, so the more further position reductions are required. This is a cost of doing business in this strategy, an insurance premium you pay. You do your best to run at a leverage level that maximizes profits subject to being able to survive the occasional crises.

Money started flowing out of quant equity in mid-July 2007, and positions were reduced in response. From August 7 to 9, 2007, the amount of the losses in the strategies, and thus the required further reductions, were larger than anticipated. However, no one was confused or panicked. At some points some quants might have rationally believed that the self-reinforcement of the crisis had passed a critical point and all the funds would have to reduce to zero positions, locking in large losses for their investors. This is a bad outcome, of course, but it’s one everyone always knew was possible. As it turned out, that did not happen, the crisis passed, and prices snapped back on Friday, August 10. A quant equity fund that had not cut positions would have been even for the week. But all real funds had to cut on the way down, and thus were smaller for the recovery on Friday than they had been for the losses on Monday through Thursday, and therefore did not get the full benefit of the recovery. Even so, many funds were even by the end of the month or the year.

One of the smaller errors in the book is to claim Goldman Sachs (NYSE:GS) ended the crisis by announcing over the weekend of August 11-12, 2007 that it was adding $3 billion to its Global Alpha fund. In fact that announcement came on August 13, while the crisis ended at the beginning of trading on August 10. There were in fact a number of factors that stopped the spiral before it became self-sustaining, (including some actions of Global Alpha on August 9).

The problem with giving all the credit to Goldman’s cash infusion announcement, aside from chronology, is that it implies the crisis was entirely a matter of confidence. Outsiders like Weatherall often have trouble accepting that the mysterious and dramatic actions of markets have rational causes, and that financial institutions are managed by intelligent and rational people. Therefore when faced with events they cannot explain, instead of digging deeper or changing assumptions, they invoke untestable explanations like failure of confidence, or animal spirits, or mania, or panics. While the failure of confidence explanation might have been tenable at the time of the crash, subsequent events demonstrated clearly that the quant equity crash was in fact a part of a much larger problem with deep economic roots.

There is no question that the events of August 2007 caused people to recalibrate quant equity strategies. It also revealed some deeper unexpected insights about markets. Quant strategies are more robust today as a result. It was a humbling experience to people who were there.

“Humbling” is not in Weatherall’s vocabulary or experience. He thinks he knows how to fix things so quant equity crashes don’t happen. This discussion is postponed until the end of the book when his solution is offered up for all financial problems. We’ll talk about that next week.

Links to previous stories in this series: Part 1, Part 2, Part 3, Part 4, Part 5, Part 6, Part 7, Part 8, Part 9, Part 10, Part 11.
No positions in stocks mentioned.

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