Andrew Lo, an MIT professor who just sold his company to Natixis Global Asset Management, has a fascinating paper on a little-noticed meltdown in the financial markets this past August. Written with his student Amir Khandani (credited as the lead author), the paper is not exactly academic and not exactly easy to read; it’s more like a combination of a whodunit detective story set in Greenwich, CT and a business school case study. The topic is three tumultuous days in the lives of hedge funds. The funds in question follow a quantitative ‘equity market neutral’ strategy.

The authors argue that the huge swings these long/short funds saw in the second week of August started with an essentially incidental event, probably the liquidation of one of funds due to unrelated events. They speculate that a big bank or hedge fund was forced to liquidate their equity market neutral portfolio, perhaps to reduce their risk due to overexposure in the mortgage markets, which have been in turmoil.

This sell-off triggered a cascade of unexpected events as the quantitative funds, firing on automatic, launched into an unchecked downward spiral.  These funds are, in normal times, engaged in a vicious arms race to develop better trading algorithms, faster technology platforms, better access to data, and newer strategies.  But the events of 6 August pushed them to their limits, and beyond.  I have heard that one of the funds had been evaluating SLERT, Novell’s low-latency Linux extensions, and rushed it into production in the August emergency.  I imagine that other IT infrastructure components were equally taxed.

Fund managers, up against margin requirements and with losses completely out of line with their forecasted risk exposure, were forced to liquidate their positions, which exacerbated the problem.  Unleveraged, Khandani and Lo estimate that a model long/short portfolio experienced a loss of 12 daily standard deviations.  Leveraged, of course, the losses were much greater, and this for a strategy that has low risk by design.

Another odd quality of the events of 6 August 2007 is that they were so large and so isolated; no one outside of the hedge fund quant universe noticed the explosion.  No other financial indicators budged.  The financial industry was dominated by concerns about low-quality mortage exposure, not long/short hedge funds.  Later in the week, the model strategy that Khandani and Lo constructed to re-enact the events of the week rebounded and made up most of the losses.  If the managers of the funds had enough liquidity, and courage, the week ended up looking pretty normal.

The paper’s conclusion is that hedge fund systemic risk seems to be greater than expected, at least in the quantitative long/short funds, many of which closely resemble each other.  With so many quants fishing in the same small pond, the rocking of one boat means that other boats may get swamped, or sink.