Quant Crash: Learning from the 2007 Crisis

Introduction
Building a Synthetic Quant Fund, By Khandani & Lo
The August 2007 “Quant Crash”
Kailash Product Performance in Quant’s Darker Days: Lower Volatility & Leverage
Post-Crash Performance
Conclusion: We Are Process Based Fundamental Investors

Introduction

In our recent paper Turbulent Times: The Temporary Inversion of Value Creation, Kailash made peripheral observations concerning some of the odd patterns seen in markets over the past few weeks. Despite experiencing a dismal month in terms of relative performance, we concluded rather optimistically under the highly scientific premise that “this too shall pass.” As we noted in that work, much of our confidence comes from the relatively reliable nature of behavioral errors that occur in markets. To take this concept beyond a sentence and actually flesh out an example, we decided to examine another recent period where markets went awry, money managers came under pressure and fear crept into the investment landscape: the 2007 Quant Crash. Aside from being relatively recent, we also felt the Quant Crash would help shed light on the many ways in which our products differ from traditional quantitative fare.¹

In our research on the Quant Crash we found two interesting academic papers by Amir Khandani and Andrew Lo in which they investigate the 2007 Quant Crash, hypothesize about what likely caused the crash, model how a typical quant strategy performed during the crash and consider ramifications from the crash including liquidity considerations². We felt that these papers were among the most insightful that we read about the quant crash. One of their key conclusions was that the quant crash was likely caused by an unwinding (i.e., closing out of several big stock positions) of one or more quant funds.

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This “unwind hypothesis” seems most consistent with the limited information that has come out about what actually happened during the crash. Another key conclusion was that the global financial system has become very inter-connected and that the unwinding of crowded trades or other disruptions in one part of the financial system can have a contagious effect on other parts of the financial system. In their second paper on the quant crash, the authors also conclude that market liquidity fell sharply during the quant crash as several funds that played voluntary roles similar to market-makers pulled back their trading activity and reduced their risk capital exposure. This drying up of liquidity in the face of the significant unwinding of positions likely made the price swings even more extreme towards the end of the quant crash. The last of their conclusions that we would like to point out is that many portfolio managers within the quant space did not realize how crowded the quant strategies had become.

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As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital Research, LLC and its affiliates (collectively, “Kailash Capital Research, LLC ”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital Research, LLC . In preparing the information, data, analyses, and opinions presented herein, Kailash Capital Research, LLC has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital Research, LLC , however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital Research, LLC and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital Research, LLC – All rights reserved.

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