Quant quake shakes hedge-fund giants

Date: Tuesday, August 14, 2007
Author: Marketwatch.com

SAN FRANCISCO (MarketWatch) -- Some of the largest firms in the $1.5 trillion hedge-fund industry have been hit this month by big losses among so-called quantitative funds, which use computer models to generate trading ideas.

The turmoil reached "historical" proportions last week, according to one hedge-fund executive, but now many of these same firms are saying there's money to be made when dislocated markets recover.

Goldman Sachs, an investment bank that's also the second-biggest hedge-fund firm, said its $9 billion Global Alpha quant fund is down 27% so far this year, with more than half of those losses coming last week.

Another $3.6 billion Goldman quant fund, called the Global Equity Opportunities fund, lost more than 30% last week. A third known as the North American Equity Opportunities fund has also lost money recently. All three have been selling positions and reducing leverage, or the amount of money they borrow.

On Monday, Goldman said it's pumping roughly $2 billion into the Global Equity Opportunities fund. It's getting an additional $1 billion from outside investors including C.V. Starr & Co., a private firm run by former American International Group Chief Executive Maurice "Hank" Greenberg, Perry Capital LLC, a hedge-fund group run by ex-Goldman trader Richard Perry, and billionaire Eli Broad.

But Goldman wasn't the only hedge-fund giant to be hit by such problems. Several other big firms that specialize in quant strategies also suffered losses, including Jim Simons' Renaissance Capital, Clifford Asness' AQR Capital Management and Tykhe Capital LLC, run by former D.E. Shaw traders.

Chain reaction

Many quant funds use a market-neutral approach, which aims to balance long positions with short trades, or bets against securities. Others are so-called statistical arbitrage funds, which analyze the historical relationships between related securities and trade when those relationships get out of whack.

Many players in this part of the hedge-fund business have similar positions and use leverage, or borrowed money, to increase their bets. However, that magnifies small losses. Some of these hedge funds also have relatively permissive redemption periods, allowing investors to take their money out every month, with 30 days' notice or less.

So if losses trigger investor redemptions, these funds may have to sell lots of their positions. That, in turn, puts more pressure on the historical relationship between related securities, handing more losses to other hedge funds in the space. If such positions are sold by lots of managers at the same time, the most leveraged funds get hit the hardest, possibly forcing big liquidations of portfolios, which triggers a chain reaction.

Renaissance

The Renaissance Institutional Equities Fund (RIEF), a giant quant fund that's designed to manage up to $100 billion in assets, was down almost 9% in early August, Simons wrote in a letter to investors late last week. MarketWatch obtained a copy of the letter.

Medallion, another fund that manages money for Simons and other Renaissance employees, was also down in August, but remains in positive territory so far this year, Simons noted.

Such losses are unusual for Renaissance. Based in Manhattan and East Setauket, N.Y., the firm employs roughly 80 PhD's who develop computer programs to seek out price anomalies in a wide range of markets, including equities, commodities, futures and options.

The Medallion fund returned 44% in 2006, topping its average annual performance of roughly 36% since 1988, according to industry publication Alpha Magazine. Simons launched RIEF in 2005. With roughly $20 billion in assets, RIEF returned about 20% last year, Alpha added.

But early August was "a most unusual period," comparable to the market crash of 1987, the junk bond crisis of 1990 and the collapse of European bonds in 1994, Simons said in his letter last week.

Some of the signals Renaissance watches to predict how markets and securities will behave are probably also used by a number of other hedge funds, Simons explained. When some of those other funds experienced losses and started liquidating their positions, that "altered the relationship of stocks to each other," causing losses at RIEF too, he said.

Such dislocation occurs "extremely infrequently," Simons added. It's painful at first, but provides opportunity later, he noted.

"While we may hedge out some market risk, our basic plan is to stay the course and, as conditions revert to the norm, we anticipate the possibility of an attractive opportunity for RIEF," Simons concluded.

Overcrowding, profit potential

Other hedge-fund firms with losses are sensing the potential to profit from any recovery.

AQR Capital Management, which has $10 billion in hedge funds, was hit this month, according to a letter Asness wrote to investors on Friday. MarketWatch obtained a copy of the letter.

Affiliated Managers Group , owns a stake in AQR and is also an investor in another quant firm called First Quadrant. The company's shares have declined recently.

Like Simons, Asness said losses were partly related to how crowded the quant arena has become in recent years. Such crowding leaves too many traders chasing an finite supply of ideas, reducing potential returns and raising risks.

AQR's stock selection strategy partly involves buying companies that are good value, have momentum, and good earnings quality while shorting or betting against firms with the opposite characteristics. That's been a winner long term, but "has very recently been shockingly bad for us and for all of those pursuing similar strategies," Asness wrote.

The past success of the strategy has attracted too many other investors, he explained.

"Now we are witnessing some of them exit, and then with reductions by almost all participants it's painful," he said. "This isn't about models, this is about a strategy getting too crowded, as other successful strategies both quantitative and non-quantitative have gotten many times in the past, and then suffering when too many try to get out the same door."

AQR knew that was a risk, but like most others using the strategy, the firm underestimated the "the magnitude and the speed with which danger could strike," he said.

When other hedge funds started unwinding their positions, that produced a "deleveraging of historical proportions," prompting some of AQR's hedge funds to reduce their exposure to the strategies, Asness added.

Still, as some investors drop out, that should increase opportunities for profit for firms that remain, he said, noting that clients have already shown more interest in AQR's aggressive market-neutral equity fund.

"The exit of many others from this style of stock picking represents a striking opportunity for future gains, which we fully intend to capitalize on for our clients," he concluded.

Bail out or opportunity?

Indeed, Goldman said on Monday that it was putting $2 billion of its own money and $1 billion of other investors' cash into its Global Equity Opportunities fund because its positions are undervalued.

Goldman's Chief Financial Officer David Viniar denied that the move was a rescue or bail out.

"I wish we were smart enough to always call the bottom. I'm not sure we can do that. We just think that as we sit here now it is an attractive opportunity," he said, according to a transcript of a conference call with analysts on Monday. "There are a fair number of assets that are selling at distressed prices that are not distressed assets."

Still, other quant firms have not been so open about their future plans. Tykhe Capital, which runs statistical arbitrage and quantitative equity funds, suffered losses of between 17% and 31% this month through Aug. 9, according to a letter the firm sent to clients last week. MarketWatch obtained a copy of the letter.

Tykhe, run by Ross Garon, Tom Ku, Xiaolei Zhu and Steve Lin, has reduced its market exposure and doesn't expect any liquidity shortage in its master funds, the firm added.

Man Group, BGI

Man Group shares fell almost 7% on Friday on concern about losses at the company's AHL quant funds. Over the two weeks to Aug. 6, the AHL strategy lost nearly 7%, based on the performance of Man AHL Diversified Futures Ltd., Dow Jones Newswires reported.

Still, the fund is still up by about 5.6% this year and Man Group shares rebounded on Monday, adding almost 7%.

Barclays Global Investors, the money management arm of U.K. bank Barclays Plc

and one of the world's largest quantitative fund managers, has also been affected this month, according to the Wall Street Journal.

The performance of BGI's 32 Capital Fund Ltd. has been challenging, the newspaper said, citing a person familiar with the fund.

Spokesman Lance Berg declined to discuss performance or the strategy of the firm's hedge funds.

"At this time we are maintaining risk levels and feel that our portfolios are positioned appropriately," Berg said, reiterating a statement he also gave on Friday.

Alistair Barr is a reporter for MarketWatch in San Francisco.