‘Crowding’ fears Will quants be able to ride out the next crisis?
For many, the summer of 1998 was defined by the Monica Lewinsky scandal enveloping the White House, the Spice Girls losing a member and France’s stunning victory at the football World Cup. But for the finance industry, that summer will forever be remembered as the period when some of the finest minds on Wall Street came undone.
The collapse of Long-Term Capital Management, the hedge fund led by Salomon Brothers’ former star trader John Meriwether and advised by Nobel laureates Myron Scholes and Robert Merton, hogged the headlines. But the market maelstrom also nearly killed DE Shaw, which had made many of the same trades as LTCM with similarly massive dollops of leverage. “The market environment was harrowing,” says Eddie Fishman, who now sits on the DE Shaw executive committee. “But the lessons served us well in subsequent crises.”
The 1998 crisis, and the “quant quake” in August 2007, are reminders that even the most sophisticated computer-powered strategies can implode. Given the popularity of quantitative investing and the competition to find and mine new trading signals, there are concerns that markets are primed for a rerun.
History indicates that the two main dangers are leverage and “crowding”. The toxicity of aggressive leverage — whether debt or through derivatives — is well-known, but too many investors crowding into the same security or trade can also cause severe damage, especially when trading conditions deteriorate quickly.
While most hedge funds use far less leverage than in 1998 or 2007, the sheer amount of money raised by quant funds since the crisis is leading to fears of crowding, lowering returns for everyone and ultimately raising the risk of an abrupt reversal, which would in turn lead to a crash as burnt investors dash for the exit.