We're in an era where "quant investing" or essentially mathematicians and statisticians of PhD caliber create programs to find any tiny discrepancy even if for seconds, and try to trade these dislocations thousands of times a day. It works great. Until it doesn't. See, models are back tested on historical data to find the discrepancies aka opportunities. The problem is historical data doesn't contain things like the biggest credit bubble of all time. Bummer.
And in one of the biggest trademarks of the Street; the more popular something gets, the less it works as more people chase the exact same trend. And with what I am sure are thousands of "me too" quant funds chasing the early hedge fund winners with similar models, the "black box" investing system seems to be collapsing under the stress of a market that doesn't go in 1 direction for more than 4 hours at a time. Pardon me while I wipe away a tear. But don't you worry, as we all know, a hedge fund manager can simply wave this away as a once in a lifetime issue, raise a new round of billions and go his merry way, finding ways to make large sums in "safe" strategies that only implode in unprecedented (i.e. historic) times... which seem to happen every 6-8 years.
We've know about Goldman Sachs Global Alpha Fund having an absolutely terrible time of things since the credit issues came to light last summer, but it appears some others in the brotherhood are also faltering. Suddenly I don't feel so bad being down 5% since Jan 1 - I'm smashing the smart guy's computers by 10% ;) It's all relative baby...
- Welcome to superstar hedge fund manager Cliff Asness' winter of discontent. Asness' AQR Capital Management has notified investors that its Absolute Return Fund, long one of Wall Street's most stellar performing quantitative hedge funds, lost 15 percent of its value through mid-February. The slide follows an 11.9 percent drop through the end of November.
- Bloomberg reported Friday that AQR flagship hedge fund now manages $2.9 billion, down from $4 billion. (27.5% drop - ouch)
- The steep losses have dealt a major blow to Asness, a University of Chicago-trained mathematician whose investing prowess catapulted him into the ranks of the super-rich, and his firm. Founded a decade ago with fellow Goldman Sachs alumni, AQR now faces the daunting prospect of employee defections, falling management fees, and credit problems.
- AQR, based in Greenwich, Conn., has long been one of the most prominent hedge funds to use complex mathematical formulas to spot - and profit from - temporary inefficiencies in stock prices. Before launching AQR, Asness and his co-founders developed the computer models that helped Goldman Sachs' Global Alpha fund return 140 percent in 1996, its first year, and regularly book handsome double-digit returns before finally collapsing last year. (it appears most of these hyper return strategies work great, until they collapse all at once)
- The strategy that Asness used is known as quantitative trading, or "black box trading" given its reliance on computers to execute trades. Over the years, AQR's founders built a money management franchise with $36 billion in assets, $11 billion of which was invested in hedge funds.
- For AQR's management, the payoff from quantitative investing was exceptional. Institutional Investor magazine regularly named Asness one of the highest-paid hedge fund managers. In 2002 and 2003, he reportedly pocketed $37 million and $50 million, respectively.
- Quantitative funds have been devastated by the market volatility that began last summer. At one point in July, the AQR Absolute Return fund booked a 13 percent loss. While it recouped about half of that loss later in the month, the fund's once-resilient mathematical models were no match in the face of a global credit crunch, the severity of which few predicted. (that's because computers don't have brains, hence they cannot predict things out more than a few seconds)
- Worse for AQR, the firm could now see its star employees head for the exits. That's because of a peculiarity of hedge fund management called the "high-water mark," in which a fund manager must recoup the amount of prior losses before earning the lucrative 20 percent and higher performance fees. AQR's rank-and-file traders and analysts now have little incentive to stick around - unless, of course, the fund's owners guarantee them compensation from a cut of their fees.
- A fund spokesman declined comment. To be sure, AQR's non-hedge assets, which are the bulk of the firm's assets, are ahead of their primary return targets for the year. (well, I am glad to hear that - wouldn't want to see any poor soul trade down to a starter mansion/yacht in CT)
