n+1 has put up a fascinating interview with a hedge-fund manager. some of it requires a little knowledge of the basic terms used in ‘the market’, for which i couldn’t recommend a better source than Doug Henwood‘s Classic, yet out of print Wall Street (available as a Creative Commons, donation-ware download.)
HFM: Goldman-Sachs had a fund that lost 30 percent, and Highbridge had a fund that lost a lot of money. Stat arb is, basically, computerized trading of a huge universe of stocks based on a set of models. And those models can be technical models like momentum or mean reversion, or it can be based on fundamental models like just “Buy stocks that have high cash-flow yields and sell stocks that have low cash-flow yields.” That’s a gross simplification, but the core of it is that—the idea that there are certain predictable relationships between either stock price history and future performance, or fundamental variables of a company and stock price performance, and these are broadly reliable. It’s not like any given stock is going to perform in line with the models. But if you’re trading a universe of 5,000 stocks, in general you’ll have enough of an edge that you’ll make money.
n+1: And so the computers themselves are making these trades?
HFM: You build the models and the computer does the trading. You actually do all the analysis. But it’s too many stocks for a human brain to handle, so it’s really just guys with a lot of physics and hardcore statistics backgrounds who come up with ideas about models that might lead to excess return and then they test them and then basically all these models get incorporated into a bigger system that trades stocks in an automated way.
n+1: So the computers are running the…
HFM: Yeah, the computer is sending out the orders and doing the trading.
n+1: It’s just a couple steps from that to the computers enslaving—
HFM: Yes, but I for one welcome our computer trading masters.
People actually call it “black box trading,” because sometimes you don’t even know why the black box is doing what it’s doing, because the whole idea is that if you could, you should be doing it yourself. But it’s something that’s done on such a big scale, a universe of several thousand stocks, that a human brain can’t do it in real time. The problem is that the DNA of a lot of these models is very, very similar, it’s like an ecosystem with no biodiversity because most of the people who do stat-arb can trace their lineage, their intellectual lineage, back to four or five guys who really started the whole black box trading discipline in the ’70s and ’80s. And what happened is, in August, a few of these funds that have big black box trading books suffered losses in other businesses and they decided to reduce risk, so they basically dialed down the black box system. So the black box system started unwinding its positions, and every black box is so similar that everybody was kind of long the same stocks and short the same stocks. So when one fund starts selling off its longs and buying back its shorts, that causes losses for the next black box and the people who run that black box say, “Oh gosh! I’m losing a lot more money than I thought I could. My risk model is no longer relevant; let me turn down my black box.” And basically what you had was an avalanche where everybody’s black box is being shut off, causing incredibly bizarre behavior in the market.
(all emphasis mine)