Can the Quant Meltdown of August 2007 repeat again in the future? by Laurent Bernut
Answer by Laurent Bernut:
Start with the Shorts in mind
In August 2007, cross sectional volatility took all markets around the world by surprise. Indices did not move much in aggregate, but constituents jumped and crashed 2-3% across the board for two days. Then, rumours of quants funds, such as Goldman Sach’s flagship market neutral unwinding, started to spread. This was the beginning of the end for quantitative market neutral funds. Their short books were the culprits.
Quants had built those models where they had an arbitrage Long good / Short poor quality stocks. Since they were market neutral, the cash proceeds from short selling could be used to leverage up almost ad infinitum. Some funds were levered up 7 times. Leverage was used to magnify otherwise underwhelming returns.
Quality was working well on the Long side. All they had to do was match exposure on the short side. They had to continue short selling in order to match the natural expanding Long side. It all worked well until volume started to dry up during the summer months.
Liquidity on the short side and chain reaction
They eventually realised it would take them weeks to unwind their short positions. So, they proceeded to pare positions down to manageable liquidity. Since everyone with roughly the same models came to the same realisation around the same time, it triggered a chain that culminated into a messy cross sectional market.
Not so safe after all
Back in those days, market neutral funds were marketed as safe investment vehicles: equity returns with fixed income volatility. When some funds started posting -4 to -8% returns during seemingly quiet markets, investors panicked. Soon enough, redemptions started to come through.
Those redemptions forced managers to close positions, thereby adding more volatility. Prime brokers asked for larger collateral as Value At Risk (VAR) increased, thereby forcing funds to reduce leverage. With reduced leverage, increased volatility and piling redemptions, it was game over for market neutral funds.
Morale of the story
It all started with one simple mistake: in their minds, the short side just happened to be some byproduct of the Long side.
Morale of the story: whatever has the power to kill a business is not a sideshow. The short side may command higher fees and reduce risk, but when neglected it has the power to bring a business down.
This will happen again in the future as long as market participants do not take the dynamics of the short side into acount