Quant Fund Meltdown Autopsy

The autopsy of the quant fund meltdown in the last weeks is beginning. In this article, Clifford Asness of AQR is quoted as saying: “We have a new risk factor in our world.” What is that factor? - some stocks are heavily owned by similar funds and others are heavily shorted by the same funds. This is an example of the "fallacy of composition" in economics. Something that works for one player at the microlevel does not neccessarily work for everyone at the macrolevel. For example, some traders have skill and are profitable but not all "traders" can profit (of course, if hedgers lose speculators could all win). Here one small fund could liquidate and exit the market profitably but not all can do this simultaneously.

TFS Capital has been looking at what factors were most responsible for the recent fall in value of quant long-short funds. They have put out a press release on their research. They identify short-covering rather than selling of long positions as the primary factor. And the stocks with the highest "short interest" - the most shorted saw the biggest moves. In other words it was a classic "short squeeze". I guess one could theorize that if a long-short fund liquidates all its positions it would be selling the long positions into relative strength as these are stocks that were identified as being good investments. Long term investors likely wouldn't panic and also sell these stocks due to the price falling a little. On the other hand covering its short positions would cause a scramble by other short-sellers to cover too. The good thing about identifying this factor is that the level of short interest in each stock is published monthly and could be included in a quantitative model. I guess one could try to track the holdings of similar hedge funds on the long side, but these are published quarterly with a lag so that data is less useful.

The bottom line is that many of these funds will rebound in value from this debacle and will have learnt from the experience and improved their strategies. In retrospect this "black swan" looks very predictable. But things are always easier in hindsight. For the individual investor it means that some of these funds are likely good values for investment now and also that if you are shorting stocks yourself monitor very closely any stocks which have high short interests.