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The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It ReviewScott Patterson's _The Quants_ was thoroughly terrible. Patterson manages to make a dizzying array (to borrow a term he overuses) of errors, packaged in a mass of hyperbolae and confused statements.
It had a few good qualities, which I'll start with. It was pretty entertaining, especially the first half, and it was a quick and easy read. It also had some interesting bits that don't appear in other books (that I'm aware of): the "second forty hours" at Renaissance and the description of AQR deciding to go back into the markets on the Friday just after the quant liquidation in August 2007. Finally, I applaud the message that risk management policies based on the normal distribution can be deeply pernicious. But the problems with this book were monumental.
The first problem with Patterson's book is that it's wrong at its core. Quant traders weren't guilty of causing the credit crisis. Some of them were victimized by it (when Lehman went bust, it took with it a bunch of money belonging to some very good, honest, and hardworking quant traders that were Lehman's prime brokerage clients). It's foolish to claim that market neutral trading, CTAs, and high frequency traders were somehow responsible for investment banks' over-leveraged, toxic balance sheets. The responsibility for this falls squarely on the shoulders of banks' managers, and perhaps also on the shoulders of free-market disciples who believe, despite all the evidence throughout history to the contrary, that regulation of human behavior is bad. The crime in this is that it dramatically changes the focus from the real source of the problem that nearly buckled our economic system--namely unchecked greed, incompetent or impotent risk managers, screwed up incentive structures, and misguided regulation--to a group of traders that people are naturally inclined to hate anyway. If Patterson's disingenuous take on the credit crisis is widely adopted, it will make for a very convenient scapegoat enabling greedy, ego-hungry Goldman Sachs execs once again to make the very same kinds of bets that (at least nearly) brought them down to begin with. Did these execs use statistics to justify their position? Sure. But to make it sound like quants are somehow responsible for the stupidity or greed of their bosses who didn't (want to?) understand the weaknesses of a model is moronic.
Another fundamental problem with this book was the arbitrariness of Patterson's use of the label "quant." Whenever it was convenient (when it sounded evil), he labeled or insinuated the activity as being quant. But math is used pretty much everywhere in finance, and it always has been. Patterson:
-Treats the computation of a price-to-book ratio (P/B) as "value investing" but taking the difference in two interest rates (X minus Y) as a "quant carry trade". Why is subtraction "quant" and division "value"? Patterson also ignores the fact that the bulk of carry trading is done by discretionary traders, such as those in the global macro space.
-Confuses financial engineers, derivatives experts employed by the sell-side investment banks to create products like Principal Guaranteed Notes, Collateralized Debt Obligations, and compute VaR with buy-side quant trading outfits that are simply speculating their own, or their clients', capital in the markets alongside everyone else.
-Calls the belief that investors are rational a "quant theory," which is stupid. It's a basic tenet of economics and not a premise of quant trading.
-Treats the efficient market hypothesis as central to quants. By definition, quant traders believe the market is at least somewhat inefficient.
-Refers to capital structure arbitrage and distressed debt trading, respectively, as a though they are quant strategies. They're not. Cap structure arb is at the intersection of legal and accounting expertise. Deciding to buy a bunch of toxic assets from a company to which you already have lots of exposure (E*Trade) is not a quant trade either.
-Equates the move by banks to take huge risk off their balance sheets through tricky accounting practices with quants.
-Somehow treats Jerome Kerveil's very plain vanilla long equity futures trade as a "complex derivatives trade," which (for the author) puts it under the heading of quant. This was a fully discretionary trade that moved markets down by 8-9% as it was unwound.
Saving the worst for last...Patterson writes: "The quants were killing Bear Stearns." This is so foolish that it should make anyone with half a brain question his integrity. Because two funds with quant trading activities withdrew their funds' capital from a brokerage house rumored to be on the brink of failing, they are somehow quants killing a bank? Are the quants who trusted Lehman (and had their money evaporate as a result) called martyrs for the cause of our financial system because they kept their capital there too long? Is it a quant model that is responsible for the manager of a fund deciding it was a matter of common sense and fiduciary responsibility to move his cash to a safer haven? What kind of nonsense is Patterson trying to peddle here? This kind of arbitrary labeling is helpful for his rhetoric, but it's also garbage. In reality, quants are no better or worse citizens of humanity than George Soros (who was responsible for breaking the Bank of England in 1992 and maybe for bringing Asian economies to the brink of collapse in 1997) or Warren Buffett.
My second problem with this book is that it is poorly written. It is full of confused statements and errors. Patterson:
-calls diversification "quant magic" (p. 180)... what the hell?
-mistakenly refers to buying credit default swaps when in fact the transaction described is a sale, carrying this mental midgetry throughout the rest of the example and drawing wrong conclusions from it (pages 189-191).
-claims that "virtually the entire quant community...embraced the derivatives explosion wholeheartedly," (p. 192) which is pretty much the opposite of correct. The derivatives explosion also resulted in the widespread selling of volatility by banks, which itself was no small pain in the neck for quants (and other trading-oriented alpha-seekers).
-claims that the August 2007 quant liquidation was "making a hash of (mom-and-pop investors') 401(k)s and mutual funds." (p. 230) The quants that liquidated in August 2007 were market neutral. This means they held roughly equal quantities of long and short positions, and that they liquidated roughly equal quantities of long and short positions. The S&P was basically flat through this crisis, meaning that no one's 401(k) was being hashed.
The style of the writing reminded me of a cross between the National Enquirer and a Batman comic. Every one of the following phrases appears in this book, many more than once, and some countless dozens of times: "nerd king," "math whiz," "math wizard," "value king," "whiz-bang," "crack team," "it was nuts," and "whiz kid." Patterson also continuously used overwrought, mixed and confused metaphors, such as: "churning wheels of the Money Grid," and later, "tentacles of the Money Grid." On p. 197, he claims that the carry trade was a "frictionless digital push-button cash machine based on math and computers--a veritable quant fantasyland of riches." This horrible abuse of the English language is also hyperbolic nonsense. On p. 270, he likens investors in 2008 to "frightened children in a haunted house," a trivializing and wholly inappropriate description. On p. 273, a nonsense sentence appears: "...its hedge funds held about $140 billion in gross assets on $15 billion in capital, or the stuff it actually owned." He climaxed on p. 307, with this gem: "Lo's view of the market was more like a drum-pounding heavy metal concert of dueling forces that compete for power in a Darwinian death dance." That, I think, sums it up. I'd say I was disappointed that the press has adopted Patterson's deeply flawed views wholesale, but in reality, I guess I didn't expect any better.
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