Can the Quant Meltdown of August 2007 repeat again in the future?
Can the Quant Meltdown of August 2007 repeat again in the future? by Laurent Bernut
Answer by Laurent Bernut:
This is an excerpt from the book i am writing on Short selling
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.
Leverage
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
Can the Quant Meltdown of August 2007 repeat again in the future?
What are the Dimensions of Trading on the Short side of Market ? Few In My View are 1) Liquidity + Availability (Float) Considerations 2) General Market Direction Drift Upwards over Long Period of Time 3) Holding Period ( Period & Capacity of Holding Positions / Margin etc) 4) Proactive Mindset (ability to Take Profit as & when available) 5) Volatility Cycle (Big Impact Sudden Reaction & general discounting mechanism ie Slowly but surely less & Less reactions getting Numb with time ) etc
Hello Al Joe,
You are right
1) Liquidity + Availability: liquididty dries up on the short side. Holders refrain from selling until price comes back to break even point. They are willing to endure pain in order to be proven right.
Availability of borrow: that is an issue that does no exist on the long side. Anyone can buy anything. On the short side, short-sellers can only short what is available. This has its counterintuitive perks: when issues are difficult to locate, it means crowded shorts, so time to look for something juicier
2) General market drift over long term: excellent point. On the short side, the market does not cooperate. The short side is about building an edge. A Long/Short portfolio should be built on two relative books: relative outperformance on the long side and relative underperformance on the short side
3) Holding period: this is a personal belief here. Periodicity is an ex-ante factor. I decide the periodicity i trade and then sometimes i get lucky. I also believe that open ended holding period (buy & Hope or Short & forget) is a form of complacency.
One thing to consider on the short side: volatility. It is the opposite of the Long side. Long positions start forgotten and unnoticed with low realised vol. They end in an epic public battle between bears and bulls.
Short positions start with high volatility and end unnoticed. Higher volatility on the short side forces participants to either shorten their duration or look past current volatility and stay for the long haul. I believe there is a middle road: scale-out/scale-in
4) Pro-active mindset: excellent point. Scale-out: take profit as positions are about to rally and scale-in: add to positions when they roll over again
The dynamics of the short side are the opposite of the long side. Successful shorts need periodic top-ups
5) Volatility cycle: bear markets start in high volatility and end in complete indifference
One thing that is also different is information asymmetry:
It is difficult for brokers to pitch shorts when the bonuses of their entire food chain (investment bankers, fixed income etc) is based on them peddling stuff as buy
No company has ever volunteered information about poor management, declining sales, in-roads from competitors