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Take it backToo Many Black Swans
Taleb defines a Black Swan as something that is an extremely rare event. When 9/11 happened, that was a Black Swan — a ten sigma or worse. When LTCM collapsed and the feds had to engineer a bailout, that was a Black Swan.
Now, the way quant hedge funds have operated is that when things went wrong for one firm, the odds were that its effected would be diluted by better performance from others. Usually, the odds of a lot of firms being affected by the same problem are rather low and consequently, their effects on the economy would be limited as well.
HFN asks an interesting question in this regard — what are the chances of several hedge funds blowing up in this regard?
Ideally, I would like to say extremely rare. But after August and after the way the market has been looking lately (shaky) in the hedge-fund world, things are beginning to look a lot less uncertain. For instance, Paul Kedrosky talks about how a lot of quant funds seem to bleeding away, with steady losses almost on a daily basis.
So, going back to HFN, they make a rather interesting observation in their article, Twilight of the Quants:
Goldman Sachs dubbed the rapid drop in its Global Alpha fund a “25-standard deviation event,” meaning it would normally occur once every 100,000 years.
Of course, with Long Term Capital Management, virtually the same statement was made about their model.
David Nissenbaum, a partner at the law firm of Schulte Roth & Zabel, says he spent a lot of time this summer on the phone with hedge fund clients. There were margin calls, issues with illiquidity, you name it. This was a historic event that was happening.
The problem is, these “historic events” are happening every three to five years.
Of course, the one interesting thing is that there is probably a simpler explanation that could be at work here (i.e. if some hedge-funds are selling short, this triggers a cascade effect). And post August ‘07, who could blame them?
I mean, just look at this graph of the Required Leverage Ratio percentages over the years (from Paul Kedrosky’s chart) -
That does not particularly look good, does it? Combine that with the fact that even post-August, the average hedge-fund seems to be performing below par.
Now, the one other thing is the fact that while a lot of these early-adopter hedge-funds had significant leverage in the beginning, almost everyone today uses some sort of algorithmic methodology to quantitatively model higher level derivatives. So, the first-mover advantage is probably running out.
That begs yet another question — does this mean that all these models lead to Rome, or that we are just looking at a shake-up of sorts? The kind that happened post-DotCom-bubble?
BPSK Said,
October 9, 2007 @ 11:23 pm
Hey- nice post. I thought that a lot of the problem with the quant hedge funds this summer has been the fact that they have all been making the same kinds of trades. Hence when one trade goes wrong, all of them get affected, all of them sell, the rest of the market gets affected, etc. etc.
Taleb’s latest book is on my must-read list. Have you read his earlier book, “Fooled by Randomness”?
Re. your last question – a shakeup is definitely coming. The question is: who will be the Amazon and Ebay (the survivors), and who will be the Sun and Petsmart (the prey)?
BPSK
Karthik Narayanaswami Said,
October 9, 2007 @ 11:47 pm
Welcome, BPSK.
Well, the problem is that while a lot of hedge funds have been making similar kinds of trades, their fundamental mathematical techniques have been different at predicting the outcome. Traditionally, the way hedging works is that you offset the risk of your investments by other means (this could be other investments, following a long/short policy, having less risky sources of capital in case things go bad etc).
So, the fact that all of them were affected by the market would mean that –
a) Their techniques/methods converged at some point, or
b) This was simple human psychology at work, of getting scared and selling short before the market had a chance to correct itself, or
c) We are missing something terribly important.
And yes, I’ve read Fooled by Randomness as well as The Black Swan. Both are rather excellent. Been meaning to post a review of TBS sometime here, too.
Indeed. But I am more interested in what it does for the infrastructure and the end users. If anything, this is only going to make the stock-markets as we know today all the more complicated.
BPSK Said,
October 10, 2007 @ 11:01 pm
“Indeed. But I am more interested in what it does for the infrastructure and the end users. If anything, this is only going to make the stock-markets as we know today all the more complicated.”
- definitely.
1987 gave us “portfolio insurance”; its aftermath gave us trading curbs (circuit breakers) that kick in when market volatility increases, which is probably a good thing.
2000 gave us the “New Economy” and Enron; its aftermath was Sarbanes-Oxley (the jury is still out on that).
The scariest thing about this current bull market has been the use of leverage by the hedgies. If this market collapses, the use of leverage is what will come under scrutiny. As far as effects on the infrastructure is concerned, we can already see the effects in the credit markets (commercial paper and repo).
BPSK
Karthik Narayanaswami Said,
October 11, 2007 @ 3:49 pm
Absolutely. And most of these blow-ups can be attributed to the fact that these guys leverage away to glory, and do not have sufficiently liquid assets. Combine the two and it’s a recipe for disaster.
Reminds me of what happened to Victor Niederhoffer, second time around. Those fat tails eventually catch up.