The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (46 page)

AQR’s poor performance shocked its investors. So-called absolute return funds were supposed to provide positive risk-adjusted returns in any kind of market—they were expected to zig when the market zagged. But Absolute Return seemed to follow the S&P 500 like a magnet.

One reason behind the parallel tracks: in early 2008, AQR had made a big wager that U.S. stocks would rise. According to its value-centric models, large U.S. stocks were a bargain relative to a number of other assets, such as Treasury bonds and markets in other countries. So Asness rolled the dice, plowing hundreds of millions into assets that mirrored the S&P 500.

The decision set the stage for one of the most frustrating years in Asness’s investing career. AQR also made misplaced bets on the direction of interest rates, currencies, commercial real estate, and convertible bonds—pretty much everything under the sun.

As the losses piled up, investors were getting antsy. AQR was supposed to hold up in market downturns, just as it had in 2001 and 2002 during the dot-com blowup. Instead, AQR was racing to the bottom along with the rest of the market.

In October and November Asness went on a long road trip, visiting nearly every investor in his fund, traveling in a private jet to locations as far afield as Tulsa, Oklahoma, and Sydney, Australia. For the rare down moments, he pulled out his Kindle,
Amazon.com
’s wireless reading device, which was loaded with books ranging from
How Math Explains the World
to
Anna Karenina
to
When Markets Collide
by Mohamad El-Erian, a financial guru at bond giant Pimco.

But Asness had little time for reading. He was trying to keep his fund alive. His goal was to convince investors that AQR’s strategies would eventually reap big returns. Many decided to stick with the fund despite its dismal performance, testimony to their belief that Asness would, in fact, get his mojo back.

By December, as the market continued to spiral lower, the pressure ratcheted up on Asness. He’d become obsessed with a tick-by-tick display that tracked Absolute Return’s dismal performance. The
stress in AQR’s office became intense. Asness’s decision to lay off several researchers as well as Rieger, his secretary, raised questions about the firm’s longevity.

Chatter about AQR’s precarious state became rampant in hedge fund circles. Asness and Griffin frequently exchanged rumors they’d heard about the other’s fund, tipping each other off about the latest slander.

Both onetime masters of the universe knew the glory days were over. In a telling sign of his diminished, though defiant, expectations, Asness coauthored a November article for
Institutional Investor
, with AQR researcher Adam Berger, called “We’re Not Dead Yet.” The article was a response to a question from
Institutional Investor
about whether quantitative investing had a future.

“The fact that we have been asked this question suggests that many people think the future of quantitative investing is bleak,” Asness and Berger wrote. “After all, upon seeing a good friend in full health—or even on death’s doorstep—would you really approach the person and say, ‘Great to see you—are you still alive?’ If you have to ask, you probably think quant investing is already dead.”

Asness knew the quants weren’t dead. But he knew they’d taken a serious blow and that it could take months, if not years, before they’d be back on their feet and ready to fight.

Ken Griffin
was also fighting the tide. But the bleeding was relentless. By the end of 2008, Citadel’s primary funds had lost a jaw-dropping 55 percent of their assets in one of the biggest hedge fund debacles of all time. At the start of January, the firm had $11 billion left, a vertiginous drop from the $20 billion it had had at the start of 2008.

What is perhaps more remarkable is that Citadel lived to trade another day. Griffin had seen his Waterloo and survived. His personal wealth fell by an estimated $2 billion in 2008. It was the biggest decline of any hedge fund manager for the year, marking a stunning fall from the heights for one of the hedge fund world’s elite traders.

Not every hedge fund lost money that year. Renaissance’s Medallion fund gained an astonishing 80 percent in 2008, capitalizing on the
market’s extreme volatility with its lightning-fast computers. Jim Simons was the hedge fund world’s top earner for the year, pocketing a cool $2.5 billion.

Medallion’s phenomenal surge in 2008 stunned the investing world. All the old questions came back: How do they do it? How, in a year when nearly every other investor got slaughtered, could Medallion rake in billions?

The answer, at the end of the day, may be as prosaic as this: The people in charge are smarter than everyone else. Numerous ex-Renaissance employees say that there is no secret formula for the fund’s success, no magic code discovered decades ago by geniuses such as Elwyn Berlekamp or James Ax. Rather, Medallion’s team of ninety or so Ph.D.’s are constantly working to improve the fund’s systems, pushed, like a winning sports team’s sense of destiny, to continue to beat the market, week after week, year after year.

And that means hard work. Renaissance has a concept known as the “second forty hours.” Employees are each allotted forty hours to work on their assigned duties—programming, researching markets, building out the computer system. Then, during the second forty hours, they’re allowed to venture into nearly any area of the fund and experiment. The freedom to do so—insiders say there are no walledoff segments of the fund to employees—allows for the chance for breakthroughs that keep Medallion’s creative juices flowing.

Insiders also credit their leader, Jim Simons. Charismatic, extremely intelligent, easy to get along with, Simons had created a culture of extreme loyalty that encouraged an intense desire among its employees to succeed. The fact that very few Renaissance employees over the years had left the firm, compared to the river of talent flowing out of Citadel, was a testament to Simons’s leadership abilities.

Renaissance was also free of the theoretical baggage of modern portfolio theory or the efficient-market hypothesis or CAPM. Rather, the fund was run like a machine, a scientific experiment, and the only thing that mattered was whether a strategy worked or not—whether it made money. In the end, the Truth according to Renaissance wasn’t about whether the market was efficient or in equilibrium. The Truth
was very simple, and remorseless as the driving force of any cutthroat Wall Street banker: Did you make money, or not? Nothing else mattered.

Meanwhile, a fund with ties to Nassim Taleb, Universa Investments, was also hitting on all cylinders. Funds run by Universa, managed and owned by Taleb’s longtime collaborator Mark Spitznagel, gained as much as 150 percent in 2008 on its bet that the market is far more volatile than most quant models predict. The fund’s Black Swan Protocol Protection plan purchased far-out-of-the-money put options on stocks and stock indexes, which paid off in spades after Lehman collapsed as the market tanked. By mid-2009, Universa had $6 billion under management, up sharply from the $300 million it started out with in January 2007, and was placing a new bet that hyperinflation would take off as a result of all the cash unleashed by the government and Fed flooding into the economy.

PDT also had a strong run riding the volatility tiger, posting a gain of about 25 percent for the year, despite its massive liquidation in October. Muller’s private investment fund, Chalkstream Capital Group, however, had a very bad year due to its heavy investments in real estate and private equity funds, losing about 40 percent, though the fund rebounded solidly in 2009. Since Muller had a great deal of his personal wealth in the fund, it was a doubly hard blow.

Weinstein, meanwhile, decided it was time to break out into the wide world on his own. But he was leaving a tangled mess behind him. By the end of the year, Saba had lost $1.8 billion. In January 2009, the group was officially shut down by Deutsche, which, like nearly every other bank, was nursing a massive hangover from its venture into prop trading and was radically scaling back on it.

Weinstein left Deutsche Bank on February 5, slightly more than a decade after he’d first come to the firm as a starry-eyed twenty-four-year-old with dreams of making a fortune on Wall Street. He’d made his fortune, but he’d been bruised and bloodied in one of the greatest market routs of all time.

Paul Wilmott
stood before a crowded room in the Renaissance Hotel in midtown Manhattan, holding up a sheet of paper peppered with obscure mathematical notations. The founder of Oxford University’s first program in quantitative finance, as well as creator of the Certificate in Quantitative Finance program, the first international course on financial engineering, wrinkled his nose.

“There are a lot of people making things far more complicated than they should be,” he said, shaking the paper with something close to anger. “And that’s a guaranteed way to lose $2 trillion.” He paused for a second and snickered, running a hand through his rumpled mop of light brown hair. “Can I say that?”

It was early December 2008, and the credit crisis was rampaging, taking a horrendous toll on the global economy. Americans’ fears about the state of the economy had helped propel Barack Obama into
the White House. The Dow Jones Industrial Average had crashed nearly 50 percent from its 2007 record, having dived 680 points on December 2, its fourth-biggest drop since the average was launched in 1896. The United States had shed half a million jobs in November, the biggest monthly drop since 1974, and more losses were coming. Economists had stopped speculating about whether the economy was sliding into a recession. The big question was whether another depression was on the way. Bailout fatigue was in the air as more revelations about losses at financial institutions from Goldman Sachs to AIG filled the airwaves.

Taxpayers wanted someone to blame. But the crisis was so confusing, so full of jargon about derivatives and complex instruments, that few of the uninitiated knew who was at fault.

Increasingly, fingers were pointing at the quants. The tightly coupled system of complex derivatives and superfast computer-charged overleveraged hedge funds that were able to shift billions across the globe in the blink of an eye: It had all been created by Wall Street’s math wizards, and it had all come crumbling down. The system the quants had designed, the endlessly ramifying tentacles of the Money Grid, was supposed to have made the market more efficient. Instead, it had become more unstable than ever. Popular delusions such as the efficient market hypothesis had blinded the financial world to the massive credit bubble that had been forming for years.

Jeremy Grantham, the bearish manager of GMO, an institutional money manager with about $100 billion in assets, wrote in his firm’s early 2009 quarterly letter to clients—titled “The Story So Far: Greed + Incompetence + A Belief in Market Efficiency = Disaster”—that EMH and the quants were at the heart of the meltdown.

“In their desire for mathematical order and elegant models,” Grantham wrote, “the economic establishment played down the inconveniently large role of bad behavior … and flat-out bursts of irrationality.” He went on: “The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous
combination of asset bubbles, lax controls, pernicious incentives, and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

In a September 2009 article titled “How Did Economists Get It So Wrong” in the
New York Times Magazine
, Nobel Prize–winning economist Paul Krugman lambasted EMH and economists’ chronic inability to grasp the possibility of massive swings in prices and circumstances that Mandelbrot had warned of decades earlier. Krugman blamed “the profession’s blindness to the very possibility of catastrophic failures in a market economy. … As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”

While the collapse had started in the murky world of subprime lending, it had spread to nearly every corner of the financial universe, leading to big losses in everything from commercial real estate to money market funds and threatening major industries such as insurance that had loaded up on risky debt.

But not every quant had been caught up in the madness. Few were sharper in their criticism of the profession than Paul Wilmott, one of the most accomplished quants of them all.

Despite the
freezing temperature outside, the bespectacled British mathematician was clad in a flowery Hawaiian shirt, faded jeans, and leather boots. Before Wilmott, spread out in rows of brightly colored plastic molded chairs, sat a diverse group of scientists in fields ranging from physics to chemistry to electrical engineering. Members of the motley crew had one thing in common: they were prospective quants attending an introductory session for Wilmott’s Certificate in Quantitative Finance program.