The Quants: Q&A With Scott Patterson
How a new breed of math whizzes conquered Wall Street and nearly destroyed it.
Patterson outlines the roots of quant investing and weaves together a very interesting tale that reads like a novel but is in fact a previously untold history lesson. The result is an interesting post-mortem of the financial crisis, the people involved, and the situations that accompanied the market boom ending in bust. (See also: Quant Fund Renaissance Technologies Founder Jim Simons Speech to MIT).
The book introduces us to some of the kings of quant investing, including:
- Peter Muller, Morgan Stanley's (MS) PDT
- Ken Griffin, Citadel Investment Group
- Cliff Asness, AQR Capital Management
- Boaz Weinstein, Deutsche Bank (DB) CDS trader
- Jim Simons, Renaissance Technologies
- Ed Thorp, the "godfather" of the quants
- Aaron Brown, of Liar's Poker fame
- Paul Wilmott, founder of mathematical finance program at Oxford University
- Benoit Mandelbrot, mathematician in 1960s warning of dangers of quant investing
Perhaps the poster child for that excess may be the quant world, who in their quest to capture alpha, dialed up risk and leverage with disastrous consequences. Patterson manages to offer a behind-the-scenes look that should be required reading for anyone seeking to understand how we got here and where we go now.
We recently sat down with Patterson to discuss some of the highlights of the book for the benefit of our readers.
Discuss your motivation in writing The Quants.
As a reporter, I've always been interested in learning about complex investment strategies because I often have a feeling that these strategies are an attempt to pull the wool over investors' eyes. Wall Street seems to have a love affair with complexity. Often it seems like the more complex something is, the more questionable. And I think it's the job of journalists to delve into these issues and suss out what's really going on, as much as possible.
As I learned more about this world, I got to know some of the biggest players, billionaires at the top of the pyramid. I saw how many of them knew one another and even played high-stakes poker games together. And they can be really interesting and eccentric. Morgan Stanley's Peter Muller, who ran a high-tech prop trading group, at one time played the piano in the New York subways for change. Cliff Asness, of AQR Capital, has a push button temper and at the same time is widely considered a genius. It seemed like a fascinating world few investors knew about -- and also one that carried massive hidden risks. I started writing the book in early 2008 and things really spiraled out of control for many of the people I was writing about, making it both an incredibly challenging reporting job but also a much more interesting story. I had little idea when I started writing how severe the crisis would become.
Did "the quants" cause the crisis or simply exacerbate the volatility?
My argument is that Wall Street -- or at least a very healthy share of it -- has become a massive quantitative machine. So if you share the view that Wall Street was behind the crisis, then you'll agree that the quants were behind it. Of course many other factors helped drive the credit bubble -- people borrowed more than they could spend, Fannie (FNM) and Freddie (FRE) helped worsen the housing bubble, etc. But if you read the book, you'll see that this was much more than a subprime lending debacle. This was a systemic, global bubble driven by Wall Street's (as well as overseas financiers') push to use more and more leverage as traders and the CEOs in charge chased returns.
Quant strategies, such as targeted hedging, as well as quantitative risk controls, were highly instrumental in maximizing leverage. I show how this was one of the biggest traps that LTCM fell into in the 1990s. There was also a huge amount of crowding in many quant strategies, something seen not only with LTCM but also in Black Monday in 1987. In the 2000s, many quant funds plowed into very similar strategies often involving going long value stocks and shorting growth stocks. When the deleveraging hit in August 2007, those crowded strategies blew up in spectacular fashion. The carry trade was another widespread technique used by quant funds (and plenty others) to boost leverage to the hilt.
Based on your look beneath the hood for this type of trading, what should happen? Should it be banned? Further regulated? Can leverage be controlled? How can we prevent this type of cascade effect from happening in the future?
I don't think quant trading can or should be banned. Any such draconian action would have a devastating effect on capital markets. In fact, I believe quants often have a beneficial impact on markets, making them more efficient. I think reform needs to come from within the quant community, an issue I address near the end of the book. Quants need to be much more careful in the use of leverage. They need to become savvier about the real world they're interacting with. They need to learn when they are in crowded trades, how following the crowd can be the most dangerous behavior of all.
Who are the major players involved here? What similarities link them together and helped send them to the top of the quant world?
I focus on a handful of quants who are in charge of large trading outfits, either hedge funds or prop trading desks at banks. I'm not sure they share any single trait aside from intelligence. Some of them, such as Peter Muller at Morgan or Jim Simons at Renaissance Technologies, seem more interested in quant trading as a science, as a problem to be solved. Ken Griffin at Citadel Investment Group seems driven by a thirst for power and money. Cliff Asness, who runs AQR Capital, is a combination of both. And Boaz Weinstein, a credit default swap trader at Deutsche Bank, is driven by competition, proving that he's the best player at the table.
I've been surprised, however, as the fact that none of these men seem willing to take responsibility for their huge losses. There seems to be a great deal of finger pointing going on on Wall Street, which worries me and is a bad omen for the next blowup.
Who is Ed Thorp? What role did he play in the quant investing world?
Thorp is perhaps the most fascinating character in the book. I call him the Godfather because he was one of the original quants -- he founded the first quant hedge fund (as far as I know) in the late 1960s. He's best known for coming up with a mathematical system to beat blackjack in the late 1950s, which he wrote about in a book called Beat the Dealer. I found, to my increasing amazement as I reported on the book, that most of today's quants read that book, as well as the book on quant investing Thorp wrote in the 1960s called Beat the Market. Bill Gross of Pimco fame, for instance, was a big Thorp fan and read both of his books. Thorp was also a key player in setting up Citadel in the late 1980s.
Thorp has an amazing career as a hedge fund manager. He posted annualized returns of about 20% and never lost money in a calendar year. He was also extremely risk averse and developed a highly sophisticated method to manage his risk, a lesson I believe many of his progeny have forgotten, to the detriment of everyone.
In the book you discuss a constant search for "The Truth." What is The Truth in the context of quant investing? How close or far did the quants come to finding the truth?
I actually heard quants literally talk about the existence of a financial Truth, a secret to the market that can be found through mathematical formulas. They believed that if they could approximate this Truth with their models, they would have the key that would unlock a fortune. It is basically, as far as I understand it, an approximation of what makes the market efficient, predicting how the market moves in and out of efficiency through mean reversion -- and capturing the ebb and flow.
Some believe that the quant fund Renaissance Technologies has in fact captured this Truth, and the returns of the fund -- 45% annualized since 1988 -- would make one think that the fund is on to something almost supernatural. But from what I understand about Renaissance, their success is based much more on a collection of very smart strategies in multiple asset classes than on any sort of mystical Truth.
This whole concept, in fact, seems dangerous, and points toward one of the biggest problems with quant strategies. The belief that the market works in one defined way, and no other, leads to the belief that more and more leverage can be thrown into a strategy. It's hubris pure and simple, and is a recipe for disaster.
The specific details are obviously proprietary and highly guarded to say the least but what specifically (if anything) did you find out about the models themselves and how they work?
I think with many of these strategies, the devil is in the details. All of these firms run multiple strategies using many, many different models and signals. The strategies are often very complex and are embedded in millions of lines of computer codes tracing very obscure signals that can decay quickly, requiring a constant search for new signals.
There is an intense focus on containing costs at the more successful hedge funds, which is understandable. Many of these firms trade rapidly and trading costs can be a big hindrance to profitability.
You seem to suggest during the crisis that the quants had some confusion about what was going on and why their models weren't working. These are some of the smartest math/stat people around. Surely they understand fat tails. Did they simply get too greedy? Was this a case of blind faith in models?
I think they always believe that "the Truth" -- efficiency, rationality, what have you -- will be restored. The market may move out of sync with their models temporarily, but eventually it will revert. But as Keynes famously said, the market can stay irrational longer than you can stay solvent. And that's where leverage can be so deadly.
Why wasn't the mainstream financial media more dialed in to the risks in the system. Minyanville was one of the few sources to sound caution (Todd, Depew, Reamer, Sedacca, Succo). Why didn't more mainstream sources get the story out there when the average person could do something about it?
I can personally attest that Minyanville was spot on with many of its warnings about the credit bubble, having been a close reader for years and having spoken with everyone you mention many times.
In defense of the mainstream media, I will say that there was plenty written about the housing market's bubble. I remember writing about it in 2003! But I think few understood the extent of the credit bubble, how it was far more serious than inflated housing prices. The entire financial system was in a bubble -- a super-bubble as George Soros calls it.
It is easy to forget, however, that the media was flashing warning signals. In June 2006, BusinessWeek wrote a feature story called "Inside Wall Street's Culture of Risk." The article opens on the 31st floor of Lehman Brother's Midtown Manhattan office as a team of executives discusses the risks the firm faces. "They pored over complicated risk models showing how tens of thousands of trading positions and financial contracts with clients would fare in the event of an Avian flu epidemic. They tested all possible scenarios that might put Lehman in harm's way." the article then quotes Lehman's Chief Administrative Officer David Goldfarb: "We are in the business of risk management 24/7, 365 days a year."
This is obviously quant speak. As I try to show in my book, the belief that risk had been tamed was one of the worst delusions of all that infected Wall Street from top to bottom.
The article ends on a note of skepticism (the subhead for this section is "Fat Tails"): "It's possible that all of the banks will show more restraint this time as they chase returns in the red-hot risk market. But don't bet on it."
What's next for the quants following the financial crisis?
Many quants have been streaming into the world of high-frequency trading, which seems to be showing signs of a bubble. My hope is that regulators will hire more quants so that they have a better understanding of the complexity driving Wall Street and can better spot signs of increased risk taking. I don't think that quants are by nature good or bad -- as I argue in my book, there are plenty of "good" quants who understand that their models aren't a reflection of reality and that fat tails are always to be feared and respected.
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