I wrote this article last October after a presentation made at a Southeastern Hedge Fund Association meeting. The title of presentation was “A Feature Presentation with Matthew Rothman, Managing Director and U.S. Head of Quantitative Portfolio Strategies, Lehman Brothers, Inc.” The meeting was held October 23, 2007 at The Ritz Carlton (Buckhead) in Atlanta, Georgia. Attendees included manager’s from Atlanta’s hedge funds, administrators, prime brokerage representatives and, of course, hedge fund lawyers.
October 24, 2007
We know the basic story for the quant blow-up this summer: in the beginning of July a few very large multi-strategy funds started experiencing large losses (at around the same time that the sub-prime sector was experiencing a melt-down). The funds began getting margin calls and needed to raise liquidity quickly beginning a chain reaction which eventually sent stocks lower, fueling the need sell more to meet margin calls.
While this is an overly simplistic reading of what happened over the summer, this overview set the stage for a presentation by Dr. Mathew S. Rothman on Tuesday to the Southeastern Hedge Fund Association. With some of the finest members of the south east’s hedge fund community gathered to examine what exactly happened with the quants this summer, Dr. Rothman, current Managing Director and U.S. Head of Quantitative Portfolio Strategies at Lehman Brothers, discussed his views on the events.
For those in attendance, including fund managers, lawyers, accountants, administrators and CFAs, the central concern was not exactly what happened in August, but what those events would mean for quants and investors going forward.
What quant managers will need to be aware of in the future
Our law firm helps to form hedge funds for new and emerging managers, including managers who are quants. It is common for lawyers and other service providers to explain to managers, especially new and emerging managers, what potential investors will look for from a quant program. We often provide clients with input on their pitchbooks and how they should “sell” their program to potential investors. In the wake of the quant blow-up this summer, and the insights provided by Dr. Rothman, we will be highlighting the following points for our quant clients.
The most important thing for potential investors is transparency. The more transparency a manager provides, the easier it is going to be to raise money. (Obviously this is not strictly true for the large established funds with stellar track records.) Quant is not an asset class and a quant program cannot be the sales pitch – emerging quant managers will need to sell their “type” of quantitative program. Managers need to get away from the “black box” mentality open up a bit, tell investors some of the inputs that will be used and also let investors know some of the inputs that will not be used – this is what we look at, this is what we throw away.
Be prepared to talk about Risk Management
Quant managers should have a good understanding of the risks of their program and be able to discuss these risks with investors. Specifically, managers will need to be able to discuss leverage and any human intervention or overrides of the models.
Understanding a program’s sustainable leverage levels is probably the most important risk management aspect of a quant program. While leverage provides a means to achieve incredible returns, it can also cripple a quant program. Levered programs may not be able to weather a prolonged downturn, which unlevered programs will.
[The fund managed by Dr. Rothman, which used no leverage, was actually up 30bps for August. While the fund was down 7% over 9 days, he was able to stick to his model because he did not have to unwind positions in order to meet margin calls. In contrast, Marketwatch reported that Goldman’s Global Alpha fund was down 22.5% for the month and J.P. Morgan’s Highbridge Capital was down roughly 18%.]
The human element and interaction with the quant model is also an important part of risk management. A quant model is just that – a model. While the model is designed to weather storms to a certain extent, some managers will include a “human override” component to the program. In some instances, allowing for a human override could prove to be exactly the wrong the strategy. Dr. Rothman noted that quant programs who stuck to their models during August were generally those programs which caught the snap-back. Those managers who rebalanced their portfolios (weather for reason of leverage or the human override) were those managers who missed the nice snap-back and ultimately were worse off then if they had followed their programs.
Be prepared for questions related to the August blow-ups
Fat tails and black swans are now standard terms investors use when talking about quant programs. It is very likely that you will be asked about fat tails and black swans by future prospective investors. Does this mean we will tell advisers to rewrite their risk models? No. However, you should at least be able to answer the question as to why your models do not address this phenomenon and it is a good idea to understand a model’s limitations during these times.
While we may not completely understand what exactly happened in August, it is clear that prospective future investors are aware of the limitations of quant models and will generally want to see more information from managers. While it is always up to the market to decide what any one manager will need to tell prospective investors, moving forward we will let our quant clients know that it would be wise to address the above items when crafting a description of their investment program and deciding how they will market their fund.