Feb. 10 (Bloomberg) -- On Aug. 7, 2007, Matthew Rothman of Lehman Brothers Holdings Inc. got off a red-eye flight in San Francisco and went to see a potential client.
“Oh my God, Matthew,” the frantic trader said, pulling Rothman toward his office. “Have you seen what’s going on?”
His portfolio had plunged, and the bloodletting continued as Rothman visited other quant funds that Tuesday, writes Scott Patterson in his sometimes overheated yet valuable book, “The Quants.” Rothman, a quantitative strategist, was baffled.
“Events that models only predicted would happen once in 10,000 years happened every day for three days,” he said after writing a report called “Turbulent Times in Quant Land.”
Suddenly, the quant math didn’t add up.
The rise of quantitative investing is one of the great financial developments of our times. Equipped with advanced degrees and superfast computers, quants revolutionized Wall Street. They also hastened meltdowns ranging from Black Monday in 1987 to the collapse of Long-Term Capital Management LP in 1998 and the Great Credit Crackup of 2007.
Most investors know little about the quants’ intellectual zealotry, arcane models and power to pump money into -- and out of -- the system. Patterson, a Wall Street Journal reporter, makes their secretive world comprehensible by tracking the turbulent lives of four quants.
Harvard Dorm
Ken Griffin is the best known of the quartet -- the six- foot math whiz who began trading convertible bonds in his Harvard dorm room and founded Citadel Investment Group LLC at the age of 22. The others are Cliff Asness of AQR Capital Management LLC; Peter Muller of Morgan Stanley’s Process Driven Trading unit; and Boaz Weinstein of Saba Capital Management LP.
The story radiates with hubris, high stakes and expensive toys, giving glimpses of poker tournaments at the St. Regis Hotel in Manhattan; a stretch-limo ride to a paintball fight outside Las Vegas; and Griffin’s garage full of Ferraris. With so much money to be made, the quants shrugged off warnings from gadflies such as Nassim Nicholas Taleb, who pounds a table in one scene, agitated by Muller’s confidence.
“You will be wiped out,” Taleb shouts. “I swear it!”
Patterson is fond of cliches, and the opening chapter is clogged with “gem-studded dresses,” “testosterone-fueled competition” and “well-heeled players.” Ignore the hype and press on. The prose gets leaner and less breathless as he explores the origins of quantitative finance.
The Godfather
The quants, it turns out, could have spared us a world of grief if they had heeded their godfather, Edward Thorp. A mathematics professor, Thorp began using math to make money in the 1960s, first at blackjack tables, then on Wall Street. His writings influenced a generation of quants.
Thorp built on an idea first mooted in 1900, when Frenchman Louis Bachelier observed in a dissertation that prices on financial markets seemed to oscillate as randomly as pollen particles seen through a microscope. The future course of the market, in this view, was a coin toss: A stock or bond was as likely to rise as to fall.
To some, that meant it was impossible to beat the market. Thorp saw something different -- a way of calculating whether stock warrants were correctly priced. His conclusion: Most warrants cost too much, given the amount you could win and the chance you would win it. Before long, Thorp was making so much money off warrants that he set up a hedge fund.
Betting System
The quants who copied him, unfortunately, ignored a vital piece of his strategy. Thorp, like Taleb, was keenly aware that non-random events can wreak havoc on models. So he scaled his bets to his bankroll. Employing a system devised by physicist John L. Kelly Jr., he would bet only a prescribed fraction of what he currently had.
The hedge-fund bubble eventually burst, of course. By October 2008, Citadel was on the verge of collapse and Muller’s PDT was in crisis mode at Morgan Stanley, Patterson says. AQR was out billions of dollars and Asness was out of control, smashing chairs and punching computer screens. Losses were mounting at Weinstein’s Saba trading group at Deutsche Bank AG. (He kept the name Saba when he broke away from Deutsche.)
What did Thorp make of his followers? Patterson visited his office in Newport Beach, California, to find out. It was February 2008 and Thorp was angry. Banks and hedge funds were blowing up because they ignored what risk management is all about: never betting so much that you can lose it all. By using massive amounts of borrowed money, they were overbetting.
“Any good investment, sufficiently leveraged, can lead to ruin,” Thorp said.
Markets forget that lesson in every boom.
“The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It” is from Crown Business (337 pages, $27). To buy this book in North America, click here.
(James Pressley writes for Bloomberg News. The opinions expressed are his own.)
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