The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (23 page)

It would be called Global Alpha, a group that would go on to become one of the elite trading operations on all of Wall Street. Global Alpha would also become a primary catalyst for the quant meltdown of August 2007.

During his
first few years at Goldman, Asness frequently came in contact with one of the chief architects of the Money Grid, Fischer Black.

Along with Thorp, Black was one of the most crucial links between post–World War II advances in academia and innovations on Wall Street that led to the quantitative revolution. Unlike the practical-minded Thorp, Black was much more of a theorist and even something of a philosopher. Among his many quirks, Black was known for his conversational sinkholes, extended periods of awkward silence that left his companions off-guard and confused. Asness had his fill of these experiences at Goldman. He would step into Black’s office, just off Goldman’s trading floor, to answer a question from the great man about some market phenomenon. Asness would quickly spit out his thoughts, only to be met by Black’s blank stare. Black would swivel his chair around, facing his blinking computer screen, and sit thinking, sometimes minutes at a time. Then, after a crushingly long silence, he would swivel back and say something along the lines of “You may be right.”

“It was like the air coming out of the
Hindenburg,”
Asness recalled.

Black believed in rationality above all else. But he was also a man awash in contradictions. A central figure in quantitative finance, he
never took a course in finance or economics. He was a trained mathematician and astrophysicist, as risk-averse as a NASA launch director, with a childlike wonder about the inner workings of stars and planets. He soaked his cereal in orange juice instead of milk, and in his later years confined his lunch to broiled fish and a butterless baked potato. Worried about a family history of cancer, the disease that eventually took his life, Black scanned his workplaces with a radiation meter and bought long cords for his computer keyboard to distance himself from the monitor. But he also had a rebellious streak. He dabbled in psychedelic drugs as a young man and trolled through pages of classified ads seeking companionship, suggesting to his estranged wife at the time that she do the same.

As a teenager growing up in Bronxville, New York, in the 1950s, Black loved to play the role of devil’s advocate, extolling communism to his conservative father and expressing admiration for Greenwich Village’s bohemians to his religious mother. He started a neighborhood group called the American Society of Creators, Apostles, and Prophets, which would gather to discuss topics such as Aldous Huxley’s experimentation with mind-altering drugs. He attended Harvard, grew fascinated with computers, and eventually gravitated toward finance after working for a management-consulting firm near Boston called Arthur D. Little.

In the fall of 1968, he met Myron Scholes, a young MIT economist from Canada. Scholes had recently started thinking about a tough problem: how to price stock warrants. Black had been mulling over the same puzzle. The pair teamed up with Robert Merton and several years later published their groundbreaking research, with a little help from Thorp, on how to price stock options.

In the early 1970s, Black took a job teaching finance at the University of Chicago. His third-floor office in Rosenwald Hall was sandwiched between the offices of Myron Scholes and Eugene Fama. He then took a job teaching at MIT for the following nine years.

But he was getting restless, stymied by the slow pace of academia. Robert Merton, meanwhile, had been working as a consultant for Goldman Sachs. He’d once suggested to Robert Rubin, then head of
the firm’s equities division and future Treasury secretary under Bill Clinton, that Goldman should consider creating a high-level position for a financial academic.

One day Merton asked Black if he knew anyone who fit the bill.

“Bob, I’d be interested in that job,” Black replied. In December he took a trip to New York to discuss the job with Rubin. In early Black was hired as head of Goldman’s Quantitative Strategies Group.

One story—perhaps apocryphal—goes that soon after taking the job, Black was getting the grand tour of Goldman’s trading floor in downtown Manhattan. The noise on the floor was deafening. Traders shouted buy and sell orders at the top of their voices. Harried men ran to and fro. It was a bizarre scene to the middle-aged Black, more used to the cloistered halls of universities where he had spent most of his career.

Black was eventually brought to the firm’s options desk to meet the head of trading. “So you’re Fischer Black,” the trader said, reaching out a hand to greet the legend. “Nice to meet you. Let me tell you something: you don’t know shit about options.”

Welcome to Wall Street, Mr. Black.

Black’s office was on the twenty-ninth floor of Goldman’s main building at 85 Broad Street, a few blocks from the New York Stock Exchange. Hanging on the wall of his office, situated next to the firm’s trading floor, was a poster of a man jogging along a dirt road that read: “The race is not always to the swift but to those who keep running.” He could often be seen typing away on his Compaq Deskpro 386 computer, obsessively entering notes into a program called Think Tank as he swigged bottle after bottle of water kept in an office credenza.

His job was simple: figure out how to turn his quantitative theories into cold hard cash for Goldman. There was something of a problem, however. Black hewed to the Chicago School notion that markets are efficient and impossible to beat. In one of his first attempts to trade, he lost half a million for the firm. But he soon realized, watching Goldman’s traders make millions of dollars from an endless cycle of inefficiencies, that the market might not be quite the
perfect humming machine he’d thought back in his ivory towers in Cambridge and Chicago.

Slowly but surely, Black was turning into one of Fama’s piranhas. Always attuned to the power of the microprocessor, he became an innovator in transforming trading into a highly automated man-machine symbiosis. Goldman’s edge, he foresaw, would be the powerful mix of financial theory and computer technology.

It was only the beginning of a dramatic change on Wall Street, the creation of the Money Grid, made up of satellites, fiber-optic cables, and computer chips, all of it tamed and fed by complex financial theories and streams of electricity. Like a spider in its web, Black was at the center of it all in his dark office at Goldman Sachs, pecking away at his computer and torturing subordinates such as Cliff Asness with his deafening silences and oracular comments about the market.

Quants make
their living juggling odds, searching for certainty, shimmering probabilities always receding into the edge of randomness. Yet for Cliff Asness, there seems to be one single factor in his success that he almost obsessively returns to: luck.

Asness readily admits that luck is not the only factor in success or failure. Being prepared and working hard puts a person in position to capitalize on that lucky chance when it comes around the corner. But luck is without question a major force in Asness’s world.

After flipping the switch on Global Alpha in 1995 in Goldman’s office at One New York Plaza, the fund promptly proceeded to lose money for eight straight days. Then its luck changed. Massively. After the initial downtrend, Global Alpha didn’t lose money for a very long time. It gained a whopping 93 percent in its first year, 35 percent in its second. A very auspicious, and lucky, start.

To show their appreciation for all the money Asness’s group started bringing in, Goldman’s bigwigs arranged a meeting with one of the biggest wigs of them all, the firm’s chief operating officer, Henry Paulson (who went on to become CEO of Goldman and then Treasury secretary in the second term of the George W. Bush administration).

Asness could have thought of better ways for Goldman’s brass to express their appreciation, but he didn’t object. He slapped together a
PowerPoint presentation to explain to Paulson exactly what he was doing.

The big day came. As Asness went to meet the firm’s notoriously prickly and long-jawed COO, he thought back to the day he’d gone to tell Fama about his research on momentum. Asness respected Fama far more than Paulson, whom he barely knew. So why was he so nervous?

The presentation involved, among other things, the various markets Global Alpha traded in. Asness rattled off a string of regions and countries: North America, Southeast Asia, Brazil, Japan.

“We trade in all of the countries in the EAFE index,” Asness added.

Paulson had been silent throughout the presentation. So he shocked Asness when he suddenly blurted out, “Hold it.”

Asness froze.

“How many countries are in that index?”

“Well,” Asness said, “it comprises Europe, Australasia, the Far East—”

“That’s not what I asked,” Paulson said curtly. “How many countries?”

“I believe twenty-one,” Asness said.

“Name ’em.”

Asness looked at Paulson in shock.
Name them? Is this guy screwing with me?

Paulson wasn’t laughing. Asness swallowed hard and started to tick off the names. France, Germany, Denmark, Australia, Japan, Singapore … He listed every country in the EAFE index. His broad forehead had sprouted a dew of sweat. Paulson sat there coolly watching Asness with his steely eyes, clenching his massive mandible. There was an awkward silence.

“That’s eighteen,” Paulsen said.

He’d been counting the names. And Asness had come up short—or so Paulson was implying. There was little Asness could say. He fumbled through the rest of the presentation and left in confusion.

Great way to show your appreciation for my hard work
, he thought.

As Global
Alpha continued to churn out awe-inspiring returns, Goldman poured in billions. By late 1997, the Quantitative Research Group was managing $5 billion in a long-only portfolio and nearly $1 billion in Global Alpha (which could also take short positions). Barely a month went by in which they didn’t put up eye-popping gains. Asness kept pulling in new talent, hiring Ray Iwanowski and Mark Carhart, alums of Chicago’s Ph.D. program in finance.

He also started teaching classes from time to time as a guest lecturer at New York University’s Courant Institute, a rising quant factory. Universities throughout the country were adding financial engineering courses. Carnegie Mellon, Columbia University, and Berkeley, as well as the stalwarts at MIT and the University of Chicago, were hatching a whole new generation of quants. The Courant Institute, a short hop from Wall Street in Greenwich Village, was gaining a reputation as a top quant farm. It was at Courant in the late 1990s that Asness met a young quant from Morgan Stanley named Peter Muller, as well as Neil Chriss. Several years later, he became a regular at the quant poker game.

Meanwhile, the success of Global Alpha was making Asness and his Chicago all-star team wealthy. In retrospect, Asness would realize he and his cohorts had been especially lucky to start investing during a period that was very good for both value and momentum strategies. At the time, however, luck didn’t seem to have much to do with Global Alpha’s success. Asness got cocky and restless. When he’d come to Goldman in 1994, he’d hoped to combine the brainy environment of academia with the moneymaking prospects of Wall Street, a kind of intellectual’s nirvana where he’d get richly rewarded for cooking up new ideas. Trouble was, he didn’t have time to do as much research as he would have liked. Goldman was constantly shuttling him around the world to meet new clients in Europe or Japan or to counsel employees. Then there were all the office politics, plus nuts like Paulson. He started thinking the unthinkable: leave the mother ship.

It wasn’t an easy decision. Goldman had given Asness his start, shown faith in his abilities, and provided him the freedom to implement
his ideas and hire his own people. It seemed like a betrayal. The more Asness thought about it, the more it seemed like a bad idea. Then he met a man with the ideal set of skills to help launch a hedge fund: David Kabiller.

David Kabiller
had been something of a wanderer among Goldman’s ranks since he’d joined the bank in a summer training program in 1986. He’d worked in fixed income, equities, and pension services. He first met Asness as a liaison between institutional investors and GSAM, which managed money for outside clients in addition to running proprietary funds for Goldman itself.

Kabiller, who’s something of a mix between a Wall Street financier and car salesman, was quick to notice that Global Alpha was raking in money. Global Alpha had a live, second-by-second computerized tabulation of its profit and loss. One day Kabiller was watching the ticking numbers fly across the screen. It was increasing, he saw with a gasp, by millions of dollars
every second
.

Something very special was going on with these nerdy quants from Chicago, he realized. They weren’t like the other people at Goldman. Not only were they smart, they were intellectually honest. They were on a quest—a quest for the Truth. He didn’t quite understand all the mumbo jumbo, but he did know that he wanted to be part of it.