The complex mathematical formulas used by quantitative equity funds did not add up in the recent market downturn, writes Frank Ahrens.

They are the powerful, cerebral and offstage actors of Wall Street, but the recent turmoil in the financial markets has yanked them into the light. They are the maths geniuses of the quant funds.

Short for "quantitative equity", a quant fund is a hedge fund which relies on complex and sophisticated mathematical algorithms to search for anomalies and non-obvious patterns in the markets. These glitches, often too small for the human eye, can present opportunities for short-term and long-term trades that yield high-profit returns.

The models replace instinct. They try to turn historical trends into predictive science, using elegant mathematics seemingly above the comprehension of your average pension fund participant or Wall Street fund manager.

Instead of veteran, market-savvy traders waving fistfuls of sell slips, the elite quant funds employ Nobel nerds with maths PhDs, often divorced from the real world. It's not for nothing that they are called "black-box" funds - opaque to outsiders, the boxes contain investment magic understood by only the wizards who conjured them up.

But the 387-point drop in the Dow Jones industrial average on August 9th and the continuing turmoil in the markets - in part attributed to massive sell-offs by the quant funds - have tarnished some of the quants' glimmering intellectual credentials and shown that, when push comes to shove, they can rush towards the exits as fast as a novice investor.

Last week, Goldman Sachs said that its Global Alpha quant fund had lost 27 per cent of its value this year because its computers failed to anticipate what the firm called "25 per cent standard deviation moves" or events so rare that Goldman had seen them only twice before in the firm's history.

On the same day Goldman revealed the bad news the firm said that it would lead a group of big-money investors, including philanthropist Eli Broad, in pouring $3.6 billion into another Goldman quant fund, aiming to shore up confidence in the quants.

Barclays Global Investors, with $450 billion of its $2 trillion in assets under quant management, began applying mathematical tools to its funds in 1978. Last week, Barclays spokesman Lance Berg said that the firm was "maintaining its investment process" despite the recent troubles. He would not say how much the Barclays quant funds had fluctuated during the period of turmoil.

The acknowledged quant king is James Simons (69), an MIT-trained mathematician with a ground-breaking theory which physicists are using to plumb the mysteries of superstring study and get at the very nature of existence itself. Simons turned his big brain on investing after his maths career, founding Renaissance Technologies quant shop. The firm pocketed $1.7 billion in investor fees last year, among the highest in the industry. In return, his clients can reap annual returns of more than 30 per cent, according to news reports.

As elegant as the models are, they cannot predict unpredictable events, or human panic, some traders say. Further, some say, too many quant funds are full of myopic brainiacs who are overly reliant on their tools.

"Most are idiots savants brought to industrial proportion," Nassim Nicholas Taleb, former quant-jock and best-selling contrarian author, said by phone from Scotland, where he is promoting his new book on improbability, The Black Swan. "They are very smart in front of a textbook but not smart enough to understand very elementary things in reality," he said.

Taleb believes in monkey-wrench events that shatter the models of the quant-jocks. He says that their algorithms do not adequately account for huge, rare anomalies, such as the current surprise credit crunch. Or the Russian credit crisis in 1998 that nearly put the superstar quant fund of the time, Long-Term Capital Management, out of business in a matter of days, saved only by a cash infusion organised by the Federal Reserve.

The sentiment is reminiscent of the demise of Enron, a company said to have been designed by geniuses but run by idiots. The oil-and-gas trader used next-generation financial tools designed by brilliant mathematicians. But they could not overcome the inept and criminal actions of the management.

The allure of a unifying, perfect mathematical formula is powerful; ithe frequently irrational financial markets, mathematic models offer the hope of cool reason and certitude, a sort of godlike wisdom.

The quant funds thrive on volatility - that is how they make their profit margins. But recent weeks have proved too volatile for some of the funds, many of them highly-leveraged, which seemingly all at once got spooked into seeking liquidity. When they ended up seeking liquidity by selling the same stocks, the August 9th plunge occurred, analysts speculate, resulting in the Dow's second-largest one-day slump of the year.

"It became increasingly transparent that many of the highly-sophisticated quant funds employed similar investment approaches and held similar core holdings," Thomson Financial wrote in an analysis of the role of the 25 largest quant funds in the market meltdown. "This resulted in the funds selling similar long stocks and covering similar short positions."

For instance, the most broadly held stock among the top quant shops, Thomson reported, is Exxon Mobil. Shares of the oil company dropped 2.4 per cent in heavy trading during the August 9th sell-off.

"If you ask the question 'Did the smart guys blow it or get it right?' I think the answer is if they knew it, it wouldn't have happened," said David Levine, a vice-president in corporate advisory services at Thomson.

"I occasionally hear broad statements like 'This just shows computer models don't always work'," Clifford S. Asness, founding principal of the quant-fund firm AQR Capital Management, wrote to his clients after the sell-off. "That's true, of course, they don't. Nothing always works. However, 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."

The value of Simons's $29 billion Renaissance Institutional Equities Fund fell by nearly 9 per cent from the beginning of the month through the August 9th drop, Bloomberg News reported. It was less of a hit than many of the other quants took, possibly reinforcing Simons's status as the Dumbledore of the quants.