Wednesday, April 9, 2008

Quants search for new math

For many years, quantitative hedge funds were hailed across the Wall Street community as inspired leaders in the next generation of finance. All the old rules about valuation, risk control, and proper evaluation were all relics of the past. The next phase of the “brave new world” of finance was being defined by these mathematical geniuses, hailed by their colleagues and the press as brilliant.

Maybe the Long Term Capital Management failure in 1998 should have served as a warning about the train wreck that was ahead. (BTW John Meriwether, the most well known of the “Geniuses” who lost billions with LTCM, has just blown up his new hedge fund). Perhaps the notion that all these quantitative hedge funds were pursuing mirror strategies with no risk control should have waved a warning flag.

Over the past six months, Hedge Funds have been closing shop at the rate of over three per week. Among the most severely impacted are the funds pursuing quantitative strategies. Many are victims of the extreme leverage used to trade the risky computational strategies.

When discussing these distressing fund blow-ups the press has started to use terms like “bet on the market” instead of focusing on quantitative math when discussing the latest victims. Most quantitative funds are suddenly viewed as pouring money down a rat hole, with the perception that their “math” was doomed to blow-up suddenly regarded as the foreseeable outcome.

Earlier Hingefire articles (see The Redefinition of Risk and Quants Meet Reality) outlined many of the problems with quantitative strategies deployed by the Wall Street wizards. It was simply a matter of time before a multi-sigma event took out many of the funds. Black swans do exist, and strategies that do not deploy reasonable risk control measures all meet the inevitable brick wall.

So what are the quants doing now their house of cards has come crumbling down? The mathematical wizards are searching for new models to replace the old ones that have gone up in smoke. Maybe this time they should throw in several cups of risk control into the recipe.

A recent article in Alpha Magazine outlines The New Math. Hedge funds are pressing ahead with new mathematical concepts for trading. The math wizards are hunting for new arcane magic that will give them an edge on the street; molecular physics, mathematical linguistics, artificial intelligence, behavioral response, and any other possible concept are on the table. The funds are also looking beyond traditional financial instruments into other asset classes. The bottom line is that most quantitative strategies are still searching for instruments which are mis-priced, yet risk control is still not a priority.

While the community has to give credit to the quants for pressing the boundaries and searching for new math that will provide them a computational edge on the market; maybe it is simply time for the wizards to focus the effort on risk control in their models to ensure long term market trading success. Even at the cost of several basis points of profit in their models and a reduction of leverage; having a strategy that does not blow up the firm every few years must have some inherent value. At minimum, it will eliminate the need to update their resumes regularly and search for a new fund to hang their math diplomas at.