AQR On The 10th Anniversary Of The Quant Crash

This month is the ten-year anniversary of the “quant crisis” or “quant quake” – that one week period in August 2007 when quantitative equity strategies like factor investing and statistical arbitrage suffered very large losses and then, in the next few weeks, made an almost full recovery. Given the current popularity of factor investing it seems a good time to review what happened that summer and discuss its relevance for today.

Following closely on the heels of the event, in September 2007, I did a write-up of what we thought happened. It took the form of an interview about the crisis with myself where I, with a lot of help from others at AQR, wrote the questions and the answers (I think you may catch me telling myself "that's a very good question"). Re-reading it today I think it holds up pretty well, though maybe it sounds a bit dated in places. So, I won't spend much time here reviewing the actual crisis other than to note that it was a true liquidity crisis, a trading "unwind." It was not some fundamental change. This is likely why it recovered so quickly (liquidity events are often highly temporal while "real" events are usually more lasting). Of course, "highly temporal" events can kill, so that isn't a dismissal, just a definition.

Let's agree that all-else-equal it would be nice to eliminate all strategies with big "left-tails" (i.e., strategies that can suffer statistically shocking down days or weeks.) We would all sleep better. But, all-else-is-not-always-equal. Some of those left-tailed strategies are pretty good. The obvious example is just getting long the stock market and earning the equity risk premium. It has a serious short-term left-tail^[1] (e.g., October 1987 and August 1998) but also has been a great long-term strategy. To achieve those long-term returns you do have to survive those left?tail events (survival as in staying solvent and invested but also not voluntarily throwing in the towel at the exact wrong time).^[2]

To start, we need to separate the ongoing debate about factor valuations from the question of short-term crash risk. In general, and not just for factors, valuations and short-term crash risk have a tenuous relationship at best.^[3] Valuations have some predictive power for long horizon factor returns, more so for slower turnover factors (like the market itself and, to a lesser extent, the value factor) than for faster ones.^[4] But small sample sizes can make long-horizon inferences difficult to make with confidence. Separately, we have also shown that factor valuation today is not very extreme.^[5] This makes the question of whether valuation-based predictability "works" a pretty theoretical one right now. But, quite separate from valuation and the long-term outlook, because factor investing is so popular today, and the underlying strategies so well-known (at least in their basic forms), I've said as part of this, this, this, and this, that factor investing is now more vulnerable to short-term extreme turbulence (a polite euphemism for a few days of getting its butt absolutely kicked).

This is the crux. Short-term extreme movements are a function of lots of people trying to do the same thing at the same time.^{[6] [7]} Of course many trying to do the same thing at the same time could itself be triggered by over-valuation. But, again, that link seems historically tenuous at best as value holds sway at the long- not short-term.^[8] Further, as we discussed back in September of 2007, factor valuations were not extreme going into that August cyclone, and thus weren't the trigger then either. Irrespective of the specific trigger, it's hard to imagine coordinated mass selling of a factor strategy occurring without it being well-known and widely implemented. That seems almost definitional.^[9] And, the factors were popular back in '07, similar to today.^[10]

So the next question is what can trigger sharp selling of a popular well-known strategy even if it's not very over-priced? Well, lots of things. I won't pretend that predicting such conflagrations is even vaguely a science, and I'd note that we didn't predict the August of 2007 quake nor did anyone else, as far as I know.^[11] But we can identify a few of those things that can start the fire. For example, it could be something like a banking crisis, an abrupt regulatory change, or a loss of ability to maintain short positions. It could be triggered by poor performance if it's severe and abrupt enough to cause people to drastically reduce their desire to take risk in those strategies. It could particularly happen if there are large and sudden redemptions facilitated by investment terms linked to poor short term performance (for example, a structured product or fund with features that require immediate redemptions based on recent poor performance - we do think this combination contributed to the '07 crash). With all that said, we're still guessing. These are, by definition, rare and wild events. One of the only things we can be fairly certain about is that the next crisis won't be a repeat of the last but they probably will rhyme.

In discussing what might cause sharp selling of factor strategies, it is useful to discuss upfront some of the different ways quantitative factor investing is implemented. Many factor portfolios are still essentially traditional, long-only and implemented without leverage, designed to beat a benchmark by overweighting the stocks preferred by the factor or factors in question. The most famous version here is often called "smart beta" though we've argued before that is mainly a relabeling of something that's been around a great while. At the other end of the spectrum are factor portfolios held in long-short form, possibly long and short similar amounts (i.e., trying to be market-neutral). Removing market exposure from a factor reduces the risk per dollar of exposure and reduces the correlation of that factor with other factors in a portfolio, leading to significantly lower risk per dollar of exposure for the multi-factor portfolio.^[12] The resulting benefit is a better risk adjusted return but at the cost of being too low risk per dollar to matter much. Leverage can, and often is, used to make such a market-neutral factor portfolio matter in the investor's overall portfolio. Thus, leverage is quite useful, but it also can be a new danger.

While we don't think anyone can reliably forecast specific events, we are more confident about what conditions make these liquidations more likely and, if they do occur, more severe. These speculations ultimately come down to who is betting on the factors and how (in what structures and with what rules - one example discussed above being structured products with specific forced redemption rules). For instance, it seems obvious that the higher the fraction of factor investors that use leverage, and the more leverage they use, the bigger the chance of another August 2007. In an unleveraged investment there are two people who can panic sell at