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The Quants Explain Disaster

Posted By Barry Ritholtz On August 18, 2007 @ 6:00 am In Credit,Derivatives,Hedge Funds,Psychology,Trading | Comments Disabled

Floyd Norris [1] posted a fabulous take down of the report from Goldman Sachs [2] entitled “The Quant Liquidity Crunch." 

The annotations are by a hedge fund manager who sent me a copy of the report to Norris. The Goldman quotes from the report are in italics, while the fund manager’s commentary is on regular type.

a) “we do not believe that current prices reflect fundamental values” — based on what?  The very models that failed you last week?

b) “No one, however, could possibly have forecast the extent of deleveraging or the magnitude of last week’s factor returns.” Bullshit. Buffett and Munger have been warning about the dangers of
excessive leverage combined with crowded trades for quite some time.

c) “what the market experienced in recent days has been completely unprecedented”
More baloney. 100-year storms happen every few years in financial
markets. Always have, always will (though every storm’s a little bit
different — maybe that’s what they mean). The only completely
unprecedented thing was the LACK of any 100-year storms for the past
few years.

d) “Going forward, we believe that successful quant managers will have to rely more on unique factors.”
Given that you don’t seem to have come up with any, why should anyone
believe that you will now? And given that every quant manager on the
planet is trying to do the same thing, what makes you think that
everyone else won’t come up with the same “more unique factors”?

e) “to protect our investors, we will need to make more of an effort to make sure that our proprietary factors remain proprietary”
Yeah, that’s the problem: other quant managers stealing your highly
proprietary factors of buying stocks with momentum or companies trading
at low multiples of cash flow.

f) “In the coming weeks, we will continue to analyze this
extraordinary period. We will also re-evaluate and re-prioritize our
research agenda in light of recent events. Stay tuned. As we continue
to study these events, we hope to gain additional insights that will
help us avoid similar problems in the future.”
Translation: we
don’t know what happened to us or what we’re going to do about it, but
we really, really, really don’t want to admit that the fundamental
premise of our business is fatally flawed and shut down, so we’ll come
up with something.

g) “we remain confident that stocks with better valuations,
higher profitability, better earnings quality, shareholder-friendly
management, strong momentum and improving analyst sentiment will
  I think they just about covered every single investing cliche here…

h) “our process should continue to add value under normal market conditions”
Finally, in the last sentence, they perhaps inadvertently reveal the
truth: their success depends on NORMAL MARKET CONDITIONS! In other
words, what they do works 99% of the time, but the other 1% of the time
they blow up — especially since they insist on using a ton of leverage
because their brilliant models tell them that what happened last week
was a 28-standard deviation event. Hint: IT WASN’T!

Fantastic stuff . . .

The Quants Explain Disaster [2]
Floyd Norris
Notions on High and Low Finance
NYT, August 15, 2007,  6:16 pm

See Also:

The Shareholder Letter You Should, But Won’t, Be Reading Next Spring [3]
Wednesday, August 08, 2007

Dear Investors, We’re… [4]
Hedge Funds Strain To Find Words to Say ‘Sorry’ for Your Losses
WSJ, August 16, 2007; Page C1

Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2007/08/the-quants-explain-disaster/

URLs in this post:

[1] Floyd Norris: http://norris.blogs.nytimes.com/

[2] take down of the report from Goldman Sachs: http://norris.blogs.nytimes.com/?p=244

[3] The Shareholder Letter You Should, But Won’t, Be Reading Next Spring: http://jeffmatthewsisnotmakingthisup.blogspot.com/2007/08/shareholder-letter-you-should-but-wont.html

[4] Dear Investors, We’re…: http://online.wsj.com/article/SB118720257346298683.html

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