Monday, August 11, 2008

Black Mesa Detecting Major Liquidation; Are The Quants About To Blow Themselves Up Again?

Black Mesa Capital, a hedge-fund firm that uses computer models to track down investment ideas, said that at least one large hedge fund or investment bank is liquidating "massive" trading portfolios, according to a letter the firm sent to its investors, last week.

"Clearly, something is amiss in the markets that few in our strategy, if anyone, have experienced before," Black Mesa's managers, Dave DeMers and Jonathan Spring, wrote.

Spring and DeMers were writing about quant funds.

According to MarketWatch:

Such "quant" funds are popular among hedge-fund investors. Many use a market-neutral strategy, which aims to balance long positions with short trades, or bets against securities. Others are so-called statistical arbitrage funds, which analyze the historical relationships between related securities and trade when those relationships get out of whack.

Many players in this part of the hedge-fund business have similar positions and use lots of leverage, or borrowed money, to increase their bets. However, that magnifies even small losses. Some of these hedge funds also have relatively permissive redemption periods, allowing investors to take their money out every month, with 30 days' notice or less.

So if losses trigger investor redemptions, these funds may have to sell lots of their positions. That, in turn, puts more pressure on the historical relationship between related securities, handing more losses to other hedge funds in the space.

If such positions are sold by lots of managers at the same time, the most leveraged funds get hit the hardest, possibly forcing big liquidations of portfolios, which triggers a chain reaction.

Two hedge-fund investors who didn't want to be identified said the current turmoil is reminiscent of the 1998 collapse of Long-Term Capital Management


Quants design their equations based on market activity of the past. The problem is that in order to build equations you need constants, you can't have just variables to buils an equaton, but in trading there are no constants. It's all variables. So what the quants do is assume that a variable that has been relatively stable is actually a constant. They plug this "constant" into their equations and start putting on huge financial positions. Everything is fine as long as the variable assumed to be a constant doesn't star to dance. Once the assumed constant variable starts to dance all hell can break lose.

The current market environment is the type where a lot variables start to dance. Thus, the potential for quants to blow themselves up is very high right now.

Black Mesa told investors that other market-neutral hedge funds had suffered losses of between 5% and 15% so far in August.

The dancing variables are clearly causing distortions.

MarketWatch quotes two hedge fund managers as saying that they didn't know how long such dislocations could last, noting that it could be two days, two weeks, two months or even two quarters.

No comments:

Post a Comment