The Quants

by Scott Patterson

  Coming into 2008, hedge funds were in control of $2 trillion. Soros was estimating that the industry would lose between $1 trillion and $1.5 trillion—through either outright losses or capital flight to safer harbors.

  Simons, looking every bit the frumpy professor with his balding pate, chalk-white beard, and rumpled gray jacket, said Renaissance didn’t dabble in the “alphabet soup” of CDOs or CDSs that triggered the calamity. His testimony provided little insight into the problems behind the meltdown, though it did offer a rare glimpse into Renaissance’s trading methods.

  “Renaissance is a somewhat atypical investment management firm,” he said. “Our approach is driven by my background as a mathematician. We manage funds whose trading is determined by mathematical formulas. … We operate only in highly liquid publicly traded securities, meaning we don’t trade in credit default swaps or collateralized debt obligations. Our trading models tend to be contrarian, buying stocks recently out of favor and selling those recently in favor.”

  For his part, Griffin sounded a note of defiance, fixing his unblinking blue eyes on the befuddled array of legislators. Hedge funds weren’t behind the meltdown, he said. Heavily regulated banks were.

  “We haven’t seen hedge funds as the focal point of the carnage in this financial tsunami,” said Griffin, clad in a dark blue jacket, black tie, and light blue shirt.

  Whether he believed it or not, the statement smacked of denial, overlooking the fact that Citadel’s dramatically weakened condition in late 2008 had added to the market’s turmoil. Regulators had been deeply concerned about Citadel and whether its demise would trigger even more blowups.

  Griffin also opposed greater transparency. “To ask us to disclose our positions to the open market would parallel asking Coca-Cola to disclose their secret formula to the world.”

  Despite Griffin’s warnings, Congress seemed to be heading toward greater oversight of hedge funds, which it saw as part of a shadow banking system that had caused the financial collapse. “When hedge funds become too big to fail, that poses a problem for the financial system,” MIT’s Andrew Lo, he of the Doomsday Clock, told the Wall Street Journal.

  Citadel didn’t fail, though it came dangerously close. Griffin, who’d once nurtured grand ambitions of a financial empire that could match the mightiest powerhouses of Wall Street, had been humbled. In the first half of the year, he’d been coming into the office late, often around 10:00 a.m. instead of the predawn hours he used to keep, so he could spend time with his one-year-old son. He couldn’t help thinking that he was paying for letting his guard down.

  But Griffin knew that the high-flying hedge fund fantasy of the past two decades would never again be the same. The mountain-moving leverage and ballsy billion-dollar bets on risky hands were all consigned to another age.

  Griffin put a brave face on. As he said on the conference call that Friday afternoon in October: “We need to face the fact that we need to evolve. We will embrace the changes that are part of that evolution, and we will prosper in the new era of finance.”

  His investors weren’t so sure. Many were asking for their money back. In December, after redemption requests totaling about $1.2 billion, Citadel barred investors from pulling money from its flagship funds. Assets at Citadel had already shrunk to $10.5 billion from $20 billion. To comply with further requests, Griffin would have to unload more positions to raise the funds, a bitter pill to swallow in a depressed market.

  Investors had little choice but to comply. But the move had infuriated many, who saw it as a strong-arm tactic by a firm that had already lost them countless millions that year.

  Griffin was also suffering a big hit to his mammoth pocketbook. Few outsiders knew exactly how much of Citadel Griffin owned, but some estimated that he held roughly 50 percent of the firm’s assets heading into the crisis, putting his personal net worth at about $10 billion, far higher than most believed. The 55 percent tumble by his hedge funds, therefore, hurt no one more than Griffin. Adding to the pain, he’d used $500 million of his own cash to prop up the funds and pay management fees typically borne by investors. Of course, he was also the biggest investor in the firm’s high-frequency quant powerhouse, Tactical Trading, which had pulled in $1 billion.

  Citadel, meanwhile, was severely hobbled. The gross assets of its hedge funds had tumbled sharply in the meltdown, falling from $140 billion in the spring of 2008 to just $52 billion by the end of the year. The firm had unloaded nearly $90 billion of assets in its frantic effort to deleverage its balance sheet, a wave of selling that had added further pressure to a panicked post-Lehman market.

  Griffin had plenty of company, of course, in the great hedge-fund shakeout of 2008—including Cliff Asness.

  Cliff Asness was furious. The rumors, lies, and the cheap shots had to stop.

  It was early December 2008. The small town of Greenwich, Connecticut, was in turmoil. The luxury yachts and streamlined powerboats lay moored in the frigid docks of the Delamar on Greenwich Harbor, a luxury hotel designed in the style of a Mediterranean villa. Caravans of limousines, Bentleys, Porsches, and Beamers sat locked in their spacious custom garages. Gated mansions hunched in the Connecticut cold behind their rows of exotic shrubbery, bereft of their traditional lacings of Christmas glitz. Few of the high-powered occupants of those mansions felt much like celebrating. It was a glum holiday season in Greenwich, hedge fund capital of the world.

  Making matters worse, a multibillion-dollar money management firm run by a reclusive financier named Bernard Madoff had proved to be a massive Ponzi scheme, one that Ed Thorp had already unearthed in the early 1990s. The losses rippled throughout the industry like shock waves. A cloud of suspicion fell upon an industry already infamous for its paranoia and obsessive secrecy.

  Ground zero of Greenwich’s hedge fund scene was Two Greenwich Plaza, a nondescript four-story building beside the town’s train station that once had housed a hodgepodge of shippers, manufacturers, and stuffy family law firms. That was before the hedge fund crowd moved in.

  One of the biggest hedge funds of them all, of course, was AQR. Its captain, Cliff Asness, was on a rampage. He wasn’t quite rolling steel balls around in his hand like Captain Queeg on the Caine, but he wasn’t far off. The battered computer monitors Asness destroyed in anger were piling up. Some thought Asness was losing his mind. He seemed to be slipping into a kind of frenzy, the polar opposite of the rational principles he’d based his fund upon. Driving his fury was the persistent chatter that AQR was blowing up, rumors such as AQR had lost 40 percent in a single day … AQR was on the verge of shutting its doors forever … AQR was melting down and tunneling to the center of the earth in a crazed China syndrome hedge fund catastrophe …

  Many of the rumors cropped up on a popular Wall Street blog called Dealbreaker. The site was peppered with disparaging comments about AQR. Dealbreaker’s gossipy scribe, Bess Levin, had recently written a post about a round of layoffs at AQR that had included Asness’s longtime secretary, Adrienne Rieger.

  “Uncle Cliff is rumored to have recently sacked his secretary of ten years, and as everyone knows, it’s the secretaries who hold the key to your web of lies and bullshit and deceit, and you don’t get rid of them unless you’re about to go down for the dirt nap,” she wrote.

  Dozens of readers posted comments on Levin’s report. Asness, reading them from his office, could tell that many came from axed employees or, worse, disgruntled current employees sitting in their cubicles just outside his office. Some of the posts were just plain mean. “I guess the black box didn’t work,” read one. Another: “AQR is an absolute disaster.”

  On the afternoon of December 4, Asness decided to respond. Unlike Griffin, who held a conference call, Asness was going to confront the rumormongers in their den: on the Internet. From his third-floor corner office, he sat before his computer, went to Dealbreaker’s site, and started to type.

  “This is Cliff Asness,” he began. He sat back, wiped his mouth, then leaned forward int
o the keyboard:

  All these inside references, yet so much ignorance and/or lies. Obviously some of these posts are bitter rants by people not here anymore, and obviously some are just ignorance and cruelty. Either way they are still lies. … For good people we had to let go I feel very bad. For investors who are in our products that are having a tough time I feel very bad and intend to fix it. Frankly, for anyone who is in a tough spot I feel bad. But for liars, and bitter former employees who were let go because we decided we needed you less than the people you now lie about … and little men who get off on anonymous mendacity on the internet,—YOU and the keyboard you wrote it on. Sorry I can’t be more eloquent, you deserve no more and will hear no more from me after this post. I’m Cliff Asness and I approved this message.

  Asness posted the rant on the site and quickly realized he’d made a terrible mistake—later he’d call it “stupid.” It was a rare public display of anger for a widely respected money manager. It became an immediate sensation within AQR and throughout the hedge fund community. Morale at the fund had been on the wane as its fortunes suffered. Now the founder of a firm known for rationality and mathematical rigor seemed to have let his emotions get the best of him.

  Investors didn’t seem to mind the dustup. What they did mind were the billions of dollars AQR had lost. But Asness was convinced the following year would be better. The models would work again. Decades of research couldn’t be wrong. The Truth had taken a shot in the mouth, but it would eventually come back. When it did, AQR would be there to clean up.

  The travails of AQR, once one of the hottest hedge funds on Wall Street, and the intense pressures placed on Asness captured the plight of an industry struggling to cope with the most tumultuous market in decades.

  The market’s chaos had made a hash of the models deployed by the quants. AQR’s losses were especially severe in late 2008 after Lehman Brothers collapsed, sending markets around the globe into turmoil. Its Absolute Return Fund fell about 46 percent in 2008, compared with a 48 percent drop by the Standard & Poor’s 500-stock index. In other words, investors in plain-vanilla index funds had done just about as well (or poorly) as investors who’d placed their money in the hands of one of the most sophisticated asset managers in the business.

  It was the toughest year on record for hedge funds, which lost 19 percent in 2008, according to Hedge Fund Research, a Chicago research group, only the second year since 1990 that the industry lost money as a whole. (In 2002, hedge funds slid 1.5 percent.)

  The Absolute Return Fund had lost more than half of its assets from its peak, dropping to about $1.5 billion from about $4 billion in mid-2007. AQR in total had about $7 billion in so-called alternative funds and about $13 billion in long-only funds, down sharply from the $40 billion it sat on heading into August 2007, when it was planning an IPO. In a little more than a year, AQR had lost nearly half its war chest.

  AQR’s poor performance shocked its investors. So-called absolute return funds were supposed to provide positive risk-adjusted returns in any kind of market—they were expected to zig when the market zagged. But Absolute Return seemed to follow the S&P 500 like a magnet.

  One reason behind the parallel tracks: in early 2008, AQR had made a big wager that U.S. stocks would rise. According to its value-centric models, large U.S. stocks were a bargain relative to a number of other assets, such as Treasury bonds and markets in other countries. So Asness rolled the dice, plowing hundreds of millions into assets that mirrored the S&P 500.

  The decision set the stage for one of the most frustrating years in Asness’s investing career. AQR also made misplaced bets on the direction of interest rates, currencies, commercial real estate, and convertible bonds—pretty much everything under the sun.

  As the losses piled up, investors were getting antsy. AQR was supposed to hold up in market downturns, just as it had in 2001 and 2002 during the dot-com blowup. Instead, AQR was racing to the bottom along with the rest of the market.

  In October and November Asness went on a long road trip, visiting nearly every investor in his fund, traveling in a private jet to locations as far afield as Tulsa, Oklahoma, and Sydney, Australia. For the rare down moments, he pulled out his Kindle, Amazon.com’s wireless reading device, which was loaded with books ranging from How Math Explains the World to Anna Karenina to When Markets Collide by Mohamad El-Erian, a financial guru at bond giant Pimco.

  But Asness had little time for reading. He was trying to keep his fund alive. His goal was to convince investors that AQR’s strategies would eventually reap big returns. Many decided to stick with the fund despite its dismal performance, testimony to their belief that Asness would, in fact, get his mojo back.

  By December, as the market continued to spiral lower, the pressure ratcheted up on Asness. He’d become obsessed with a tick-by-tick display that tracked Absolute Return’s dismal performance. The stress in AQR’s office became intense. Asness’s decision to lay off several researchers as well as Rieger, his secretary, raised questions about the firm’s longevity.

  Chatter about AQR’s precarious state became rampant in hedge fund circles. Asness and Griffin frequently exchanged rumors they’d heard about the other’s fund, tipping each other off about the latest slander.

  Both onetime masters of the universe knew the glory days were over. In a telling sign of his diminished, though defiant, expectations, Asness coauthored a November article for Institutional Investor, with AQR researcher Adam Berger, called “We’re Not Dead Yet.” The article was a response to a question from Institutional Investor about whether quantitative investing had a future.

  “The fact that we have been asked this question suggests that many people think the future of quantitative investing is bleak,” Asness and Berger wrote. “After all, upon seeing a good friend in full health—or even on death’s doorstep—would you really approach the person and say, ‘Great to see you—are you still alive?’ If you have to ask, you probably think quant investing is already dead.”

  Asness knew the quants weren’t dead. But he knew they’d taken a serious blow and that it could take months, if not years, before they’d be back on their feet and ready to fight.

  Ken Griffin was also fighting the tide. But the bleeding was relentless. By the end of 2008, Citadel’s primary funds had lost a jaw-dropping 55 percent of their assets in one of the biggest hedge fund debacles of all time. At the start of January, the firm had $11 billion left, a vertiginous drop from the $20 billion it had had at the start of 2008.

  What is perhaps more remarkable is that Citadel lived to trade another day. Griffin had seen his Waterloo and survived. His personal wealth fell by an estimated $2 billion in 2008. It was the biggest decline of any hedge fund manager for the year, marking a stunning fall from the heights for one of the hedge fund world’s elite traders.

  Not every hedge fund lost money that year. Renaissance’s Medallion fund gained an astonishing 80 percent in 2008, capitalizing on the market’s extreme volatility with its lightning-fast computers. Jim Simons was the hedge fund world’s top earner for the year, pocketing a cool $2.5 billion.

  Medallion’s phenomenal surge in 2008 stunned the investing world. All the old questions came back: How do they do it? How, in a year when nearly every other investor got slaughtered, could Medallion rake in billions?

  The answer, at the end of the day, may be as prosaic as this: The people in charge are smarter than everyone else. Numerous ex-Renaissance employees say that there is no secret formula for the fund’s success, no magic code discovered decades ago by geniuses such as Elwyn Berlekamp or James Ax. Rather, Medallion’s team of ninety or so Ph.D.’s are constantly working to improve the fund’s systems, pushed, like a winning sports team’s sense of destiny, to continue to beat the market, week after week, year after year.

  And that means hard work. Renaissance has a concept known as the “second forty hours.” Employees are each allotted forty hours to work on their assigned duties—programming, researching markets, buildi
ng out the computer system. Then, during the second forty hours, they’re allowed to venture into nearly any area of the fund and experiment. The freedom to do so—insiders say there are no walledoff segments of the fund to employees—allows for the chance for breakthroughs that keep Medallion’s creative juices flowing.

  Insiders also credit their leader, Jim Simons. Charismatic, extremely intelligent, easy to get along with, Simons had created a culture of extreme loyalty that encouraged an intense desire among its employees to succeed. The fact that very few Renaissance employees over the years had left the firm, compared to the river of talent flowing out of Citadel, was a testament to Simons’s leadership abilities.

  Renaissance was also free of the theoretical baggage of modern portfolio theory or the efficient-market hypothesis or CAPM. Rather, the fund was run like a machine, a scientific experiment, and the only thing that mattered was whether a strategy worked or not—whether it made money. In the end, the Truth according to Renaissance wasn’t about whether the market was efficient or in equilibrium. The Truth was very simple, and remorseless as the driving force of any cutthroat Wall Street banker: Did you make money, or not? Nothing else mattered.

  Meanwhile, a fund with ties to Nassim Taleb, Universa Investments, was also hitting on all cylinders. Funds run by Universa, managed and owned by Taleb’s longtime collaborator Mark Spitznagel, gained as much as 150 percent in 2008 on its bet that the market is far more volatile than most quant models predict. The fund’s Black Swan Protocol Protection plan purchased far-out-of-the-money put options on stocks and stock indexes, which paid off in spades after Lehman collapsed as the market tanked. By mid-2009, Universa had $6 billion under management, up sharply from the $300 million it started out with in January 2007, and was placing a new bet that hyperinflation would take off as a result of all the cash unleashed by the government and Fed flooding into the economy.

  PDT also had a strong run riding the volatility tiger, posting a gain of about 25 percent for the year, despite its massive liquidation in October. Muller’s private investment fund, Chalkstream Capital Group, however, had a very bad year due to its heavy investments in real estate and private equity funds, losing about 40 percent, though the fund rebounded solidly in 2009. Since Muller had a great deal of his personal wealth in the fund, it was a doubly hard blow.