STREET DOGS

FROM an article at the GlobalSlant: I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes “Black Box” trading was very tricky. The algorithms may work for a while (even a very long while) and then, inexplicably, they’ll just completely “blow up”. To him the most important component to quantitative trading was not the creation of a good model. The real challenge, for him, was to “sniff out” the degrading model prior to its inevitable “blow-up”.

And I quote his humble, resolute observation: “because, you know, eventually they all blow up” … as most did in August 2007. (When) years of monthly returns with exceedingly low volatility were turned “inside out” in just four to six weeks as many funds suffered monthly losses greater than 20% which was previously considered highly improbable and almost technically impossible …. Many survived but only by changing the liquidity rules to suit their own needs. Basically, as an investor, you could not “get out”.

Anyway, to follow up on my dialogue, I asked “why do they all “blow up”? And if they all eventually “blow up” then why are we even doing this?”

He answered the second part of the question first, and I paraphrase, “We are all doing this because we can all make a lot of money before they “blow up”. And after they do “blow up” nobody can take the money from us. As to why all these models eventually “blow up”: “Because despite what we all want to believe about our own intellectual uniqueness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded … and when we all want to liquidate (these similar trades) at the same time … that’s when it gets really ugly.”

Michel Pireu — e-mail: pireum@streetdogs.co.za