What Happened to the Quants in August 2007?

Abstract

Abstract In Chapter 17, we use the simulated returns of a specific set of long/short equity portfolios to understand what happened to quantitative hedge funds during the month of August 2007, when they all experienced large losses at the same time. Using five valuation factors to construct simulated returns, we find evidence that the ‘Quant Meltdown’ of August 2007 began in July and continued until the end of 2007. The simulation of a high-frequency market-making strategy exhibited significant losses during the week of 6 August 2007, but was profitable before and after, suggesting that the financial dislocation was due to market-wide deleveraging among an entire subsector of hedge funds, as well as a sudden withdrawal of market-making risk capital that started on 8 August. Two unwinds are identified—one on 1 August, starting at 10:45am ET and ending at 11:30am ET, and a second at the open on 6 August, ending at 1:00pm ET—that began with stocks in the financial sector long book-to-market and short earnings momentum.