Quant Fund Pain: Is The Worst Over?

| About: Goldman Sachs (GS)

There have been a lot of losses in quant-based hedge funds in recent days. But the smart money, it seems, is bullish:

Goldman Sachs Group Inc. (NYSE:GS) announced it and other investors will inject $3 billion into a quantitative fund that has seen its performance "suffer significantly."

As a result, the company has cut risk and leverage for the Global Equity Opportunities fund, as well as its Global Alpha internal hedge fund and North American Equities Opportunities Fund, another quantitative fund.

Global Equity Opportunities, which has both long and short positions, is getting the funds from Goldman, C.V. Starr & Co., Perry Capital LLC and Eli Broad. C.V. Starr, an insurance broker, is headed by former American International Group Inc. Chairman and Chief Executive Hank Greenberg.

"We consider this an attractive investment opportunity," Goldman said in a statement.

The cash injection comes at a time when quant funds generally, including Global Alpha andmany others , are hurting badly. The classic "but our models said this could never happen" quote came on Saturday, from Matthew Rothman of Lehman Brothers:

"Wednesday is the type of day people will remember in quant-land for a very long time," said Mr. Rothman, a University of Chicago Ph.D. who ran a quantitative fund before joining Lehman Brothers. "Events that models only predicted would happen once in 10,000 years happened every day for three days."

As Yves Smith says,

It is patently absurd to talk about a "one in 10,000 year event" for markets and instruments that clearly won't exist in 10,000 years. It behooves someone who is dealing in mathematical terms to describe the probabilities more precisely. And the very fact that this supposed impossibly improbable event happened three days running says there is something wrong with his, and the general, assessment of the likelihood of outcomes. What happened this week wasn't as extreme as the 1929 crash, and my calendar says that happened a mere seventy-eight years ago.

How can you judge what would be a "one in every 10,000 year" event, much the less a "one in every 100 year event" when you have at most 10 or 20 years of data?

Smith, along with Brad DeLong, blames the quant-fund blowup on "fat tails". But for a more considered view it's worth going to the Bearish Hedgie himself, Rick Bookstaber. Rather than talk vaguely about fat tails, he blames three factors in particular: the leverage in these funds; the overlap in strategies between these funds; and the sheer amount of money invested in these funds, which exceeds the investment opportunities available.

Bookstaber's view makes more sense than talk of fat tails, at least to me, if only because there was nothing in the markets last week which was particularly unusual. The thing which killed the quant funds, it seems, is that their relative-value plays went the wrong way: they were long large-caps and short small-caps, say, when large-caps went down and small-caps went up.

But Goldman, along with smart money like CV Starr, sees any short-term dislocation in prices right now as a buying opportunity – and I can't say that I blame it. The markets aren't behaving irrationally, per se – they're just not behaving in the way that the computer models said that they would. Goldman's making a bet that the models will still work after today – that we haven't entered a new market paradigm where they don't work at all. I think they're probably right, since the forces which led to the quant-fund losses do seem to have been very short-term in nature.