1) many funds are pursuing the same strategies, using significant leverage
2) problems in the credit markets forced some multi-strategy funds to sell liquid equity positions in order to meet margin calls
3) positions commonly held by quant funds deteriorated in a correlated manner
Conclusion: systemic risk galore!
More discussion in the Economist.
What Happened to the Quants in August 2007?
ANDREW W. LO
Massachusetts Institute of Technology
September 20, 2007
During the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses. Based on empirical results from TASS hedge-fund data as well as the simulated performance of a specific long/short equity strategy, we hypothesize that the losses were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios. Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction. These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies. A significant rebound of these strategies occurred on August 10th, which is also consistent with the sudden liquidation hypothesis. This hypothesis suggests that the quantitative nature of the losing strategies was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. The fact that the source of dislocation in long/short equity portfolios seems to lie elsewhere - apparently in a completely unrelated set of markets and instruments - suggests that systemic risk in the hedge-fund industry may have increased in recent years.