2 recent papers pick over the causes and conclusions of the recent market turmoil
(NEW YORK) Smart investors love crises. People panic, everything gets out of whack, securities get cheaper, and the world gets more interesting.
Academic types also love crises because they produce data, which prompt questions and every once in a while produce some answers.
August, the month in which everything went awry on Wall Street, offered up fascinating data.
The financial world trembled, which it does every so often, and even though everyone seemed to know it was coming, everyone seemed surprised.
Two recent papers, one academic and one written for investors, examine the August unwind.
They reach similar conclusions about risk (there is more of it) and the cause of the collapse (an unknown multibillion-dollar fund unwinding), but they differ slightly on what it means for the types of hedge funds that were most affected.
In separate papers, Andrew Lo, a professor of finance at the Massachusetts Institute of Technology who just sold his hedge fund, AlphaSimplex, and Clifford Asness, the founder of AQR, a US$37 billion hedge fund, concluded that the market craziness started when a large multi-strategy fund or a proprietary desk suddenly started to dump its positions in early August.
That set off a wave of de-leveraging, or selling, that in turn caused stocks to do strange things.
Specifically, cheap stocks, or value stocks, got pummelled, and expensive stocks, or popularly shorted stocks, rose.
This caused a lot of pain on the street, especially among quantitative hedge funds, or quants.
Prof Lo’s research, which builds a very basic quantitative model and then tests what would happen to it during the August unwind, concludes that the proliferation of hedge funds using similar investment strategies has led to more risk in the system.
If this seems obvious, be mindful that a lot of people have argued otherwise, and Prof Lo is trying to prove it, not grandstand about it, which is unusual when it comes to any topic related to hedge funds.
According to his analysis, assets in certain strategies – quantitative and long/short equity, both of which generally try to buy cheap stocks and sell expensive ones – have soared and returns have plummeted (these are data points, not conclusions).
From 1995 to 2007, assets in two strategies – equity market neutral (a quantitative model) and long/short equity – skyrocketed to US$160 billion from about US$10 billion. Over the same period, yearly average daily returns of Prof Lo’s portfolio fell to 0.13 per cent from 1.3 per cent.
So to achieve the returns that investors expected, his fund had to increase leverage to about nine times from about two times.
When the unwind came, all those funds with all that leverage resulted in a lot of panic.
‘Now that we have so many boats in the harbour, you can’t whiz by at 50 knots without rocking a few boats,’ Prof Lo said in an interview.
‘In the middle of the ocean, your wake has no impact, but in a crowded harbour, a fast exit can cause quite a disruption.’
In his paper, Mr Asness reached a similar conclusion. ‘I have said before that ‘there is a new risk factor in our world’, but it would have been more accurate if I had said ‘there is a new risk factor in our world and it is us’,’ he wrote in his Q&A letter to investors.
However, he drew a slightly different analogy than Prof Lo. Mr Asness conceded that the harbour is more crowded, but he argued that the problem was not that there were too many boats but that all the boats raced for the same exit. The upshot: There is still room for sailing, which in this analogy means there is still room to make money.
Asness argued that the spread between expensive and cheap stocks, what he called the ‘value spread’, was not that tight before the August unwind and is now wider than the historical norm.That suggests there is room to make money.
‘If too much capital had been attracted to these strategies, then that spread should have been tighter,’ he wrote.
‘Since it hasn’t, it is reasonable to believe that the growth in these strategies has at least been matched by the growth in the behaviour that makes them work.’
Put another way: ‘The growth in the quants seems to be reasonably balanced by those who want to take the other side of the quants,’ Mr Asness said. In other words, there is always someone on the other side, willing to sell cheap stocks and buy expensive ones.
So is the harbour half-empty or half-full? Since hedge funds are not particularly transparent, and no one has particularly useful data on them, no one really knows.
One thing is clear: The harbour, after the August unwind, is less full than it was – a lot of boats have been wiped out.
‘I agree with Andy that these strategies will make less money going forward,’ Mr Asness said.
‘But as of now they are cheap strategies.’ In other words, smooth sailing until the next storm.
Source: NYT (Business Times 29 Sept 07)