“What Happened To The Quants In August 2007?”

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.

Context and the future of music

And every one of them words rang true
And glowed like burning coal

Ian Rogers from Yahoo Music, and formerly of Nullsoft, says it straight: check out his blog entry and slides from a talk he gave to “some friends in the music industry.” (Nice use of Flickr for slide presentation.)

Eight years ago he, and anyone else who was thoughtful about the issue, knew that legally selling music by the individual track in an unprotected MP3 format was the future of the music industry. But it’s taken eight years for someone, i.e., Amazon, to actually do it.

Eight years resonates with me, because I remember a small internally-focused conference we had on the future of what was then called e-business in late 1999 or early 2000, almost exactly eight years. One of the ‘tracks’ of the conference was on the future of the music industry and I remember being told by one of the presenters, who was with Sony Music if I recall correctly, that it was a ‘future that has already happened,’ in Peter Drucker’s felicitous phrase. He described more or less exactly what Rogers is saying, eight years later.

People knew.

I remember thinking that it was unclear to me exactly how the future of digital music was going to unfold — remember, there was no such thing as the iPod yet — and particularly if subscription services were going to win out over album or song purchases. But those were details; Rogers is absolutely right that this has been waiting to happen for *eight* years now. Incredible.

I especially like his point about the “context” of the music becoming increasingly important; he says that this is a limitation of iTunes, since it’s a music spreadsheet. Which is mean, but funny. And true.

There’s a rule (I might be making this up, so don’t tell your kids) that says that a financial derivatives market will grow to eventually become ten times the size of the underlying physical market, so that the oil futures market, for example, is bigger than oil contracts market by an order of magnitude.

I think (and I’m definitely making this up; tell your kids) that the same applies for interpretations of a source, so that the Bob Dylan discussion ‘market’ (here for example) should be at least ten times the size of the actual Dylan corpus. This is certainly true for religious texts; the Talmud, the derivatives market, is much larger than the Torah — the physical market, to torture the metaphor — as is the Buddhist commentarial tradition, which is enormous, largely untranslated, and little-read in the West to date.

The problem with the Dylan commentarial tradition, besides being dry and mostly lacking a sense of humor as per the requirements of the genre, is that it’s faced with a moving target; it’s as if they were still writing the New Testament.

But imagine, if you will, if you could embed the source texts along with your commentary, just like the religious authors do. That would put your music into context. And there are always going to be large contexts, communities, or commentarial traditions. So maybe the quote at the top is referring to Baudelaire, or the Bible, or to a 13th century poet. But I could help Bob sell some music if I could link to the source so that my dear readers could listen to the song as they read about it, or the future of music.

Mozy update

Back in April, Mozy announced a deal to provide backup services for all of GE’s employees — all 300,000 of them — which impressed me enough to start using Mozy’s free offering.

You download a small application, tell it the folders or filetypes you want to back up, with a 2GB limit, and it trickles the updates back to their servers during periods where you’re away from your machine. I’ve used it successfully with Windows and Mac. You agree to accept the occasional promotional email from Mozy-approved advertisers, but I don’t think I’ve gotten any. It’s a great service that simply solves the terrifying backup problem.

Now TechCrunch is reporting that EMC has acquired them for $76m, on just $1.9m in venture capital. Good move for EMC and great news for the Mozy guys, who had earlier rebuffed offers from Google.

I still would like to see an open source version that can use a variety of back-ends including S3; I think that would be an ideal solution. But for now, Mozy!

Tesco coming to Redlands!

Tesco, the big British grocer, has a secretive $1b plan to open medium-format stores in the US, starting in the Southwest. I read something about it in The Economist a while ago (PR here), but just figured out that the distribution center, near the old March Air Force base, is going to support, among others, a store in my town of Redlands. They’re planning to rapidly build out medium format stores, positioned between Whole Foods and Ralph’s, say. There’s some question whether the format, which has been wildly successful in the UK, will work in the US, but Tesco has decided to go big quick and trust that their ability to rapidly respond to changing customer needs will serve them. Just in the same way that a British family will pick up dinner and groceries at the Tesco store near the train station on the way home, the new Tesco in Redlands is going to be on the route from our house to our kids’ school.

Redlands doesn’t have a Whole Foods, much to my chagrin (but good for my wallet), but it does have a successful Trader Joe’s and the usual large-format players: Ralph’s, Von’s, Albertson’s, Wal-Mart and Cosco. Interestingly, my neighborhood also has an 0ld-school family-owned medium-sized grocery, Gerrard’s, that would seem to be in the cross-hairs of Tesco’s plans. But maybe not.

This should be interesting.