BOOK REVIEW: The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It By Scott Patterson Random House; £12.99 (€15)
THERE ARE many dramatic moments and a good dose of schadenfreude in Scott Patterson's The Quants. Patterson, a Wall Street Journalreporter, provides a riveting account, as the subtitle promises, of the rise and fall of a group of traders, most of them masters of mathematics, poker and the universe.
They are some of the brightest minds in finance, dubbed “quants” because they specialise in quantitative, maths-based finance.
Ken Griffin of Citadel, Cliff Asness of AQR, Deutsche Bank’s Boaz Weinstein, the elusive Jim Simon of Renaissance Technologies and the invisible Pete Muller, who ran PDT (an in-house proprietary trading group at Morgan Stanley), were among the most powerful market players on Wall Street – at least for a while. At their peak, these traders were a force with which to be reckoned. Between them they controlled about $150 billion (€109 billion) and, because many used lots of borrowed money as well, they collectively had assets of as much as $1,000 billion.
But many of them were then crushed in the market meltdown, having failed to factor in just how vulnerable their models were.
Quants are a breed of trader that spends little time on such variables as the quality of a company’s management. Instead, they focus on relationships and patterns in an effort to predict the direction of asset prices, which may in turn lead them to discover “inefficiencies” and “mispricings” on which to capitalise. There is, of course, an implicit assumption that such inefficiencies and mispricings will be corrected because markets are ultimately efficient.
“Even as the mortgage market imploded, quant funds such as AQR, Renaissance, Saba and Citadel believed they were immune to the trouble,” Patterson writes, “either because they didn’t dabble in subprime or because they believed they were the smart guys in the room and had either hedged against losses or were on the right side of the trade and were poised to cash in.”
To a novice in this high-powered world the faith in the models is almost touching. There were plenty of signs along the way that the models were anything but infallible. Equally intellectually endowed Cassandras, such as Nassim Nicholas Taleb, warned that the models failed to account for sudden price swings that change everything, as had the mathematician Benoit Mandelbrot a generation earlier. No matter. It was as if the models had a life of their own, apart from the humans who programmed them.
There is a wonderful description of a Goldman Sachs quant fund that almost imploded in the summer of 2007. Global Alpha “was trapped in a self-reinforcing feedback loop”, Patterson says. As the fund’s model dictated ever more selling, that caused greater volatility in prices, which then forced the model to cause even more selling in a technology-driven death spiral. At the end of the summer, chastened Goldman portfolio managers told their investors: “There is more money invested in quantitative strategies than we appreciated.”
Readers, like investors, might find this a fairly stunning admission of a lack of common sense.
The whizzes who studied market relationships so exhaustively failed to grasp some elementary truths, such as that distress in one market can lead to selling in an entirely different and hitherto unrelated market. That was the main lesson from the 1998 implosion of quant fund Long Term Capital Management, but it was soon forgotten.
Some of the characters in The Quantsare almost caricatures in their lifestyle and behaviour. There are the near-mandatory references to private jets, high-stakes poker games and temper tantrums. Asness, for example, destroys his computer screen and his staff fear he has gone mad.
If there is a weakness, it is that Patterson could have been more ambitious. He draws no larger lesson from the debacle he has so vividly conveyed, whether for investors or for regulators. – (Copyright The Financial Times Limited 2010)
