My first experience as a hedge fund manager was seeing hundreds of millions of dollars being lost. The losses came with remarkable consistency. Looking at the blinking screen with live P&L (profits and losses), I saw new million-dollar losses every 10 minutes for a couple of days—a clear pattern that defied the random walk theory of efficient markets and, ironically, showed remarkable likeness to my own theories.
Let me explain, but let’s start from the beginning. My career as a finance guy started in 2001 when I graduated with a Ph.D. from Stanford Graduate School of Business and joined the finance faculty at the New York University Stern School of Business. My dissertation research studied how prices are determined in markets plagued by liquidity risk, and I hoped that being at a great university in the midst of things in New York City would help me find out what was going on both inside and outside the Ivory Tower.
I continued my research on how investors demand a higher return for securities with more liquidity risk, that is, securities that suffer in liquidity crises. Digging a layer deeper, my research showed how liquidity spirals can arise when leveraged investors run into funding problems and everyone runs for the exit, leading to a self-reinforcing drop and rebound in prices.
I tried my best to do relevant research and, whenever I had the chance, I talked to investment bankers and hedge fund traders about the institutional details of the real markets. I also presented my research at central banks and tried to understand their perspective. However, when I really wanted to understand the details of how trade execution or margin requirements actually work, I often hit a roadblock. As an academic outside the trading floors, it was very difficult to get to the bottom of how markets actually work. At the same time, traders who knew the details of the market did not have the time and perspective to do research on how it all fits together. I wanted to combine real-world insight with rigorous academic modeling.
In 2006, I was contacted by AQR, a global asset manager operating hedge funds and long-only investments using scientific methods. I was excited and started consulting shortly after. Working with AQR opened a new world to me. I became an insider in the asset management world and finally had access to people who knew how securities are traded, how leverage is financed, and how trading strategies are executed, both my colleagues at AQR and, through them, the rest of Wall Street. Most excitingly, my own research was being put into practice.
After a year, AQR convinced me to take a leave of absence from NYU to join them full time starting on July 1, 2007. Moving from Greenwich Village to Greenwich, CT, the first big shock was how dark and quiet it was at night compared to the constant buzz of Manhattan, but a bigger shock was around the corner.
My job was to develop new systematic trading strategies as a member of the Global Asset Allocation team, focusing on global equity indices, bonds, commodities, and currencies, and I also had opportunities to contribute to the research going on in the Global Stock Selection and arbitrage teams. However, my start as a full-time practitioner happened to coincide with the beginning of the subprime credit crisis.
As I began working in July 2007, AQR was actually profiting from some bets against the subprime market but was starting to experience a puzzling behavior of the equity markets. As a ripple effect of the subprime crisis, other quantitative equity investors had started liquidating some of their long and short equity positions, which affected equity prices in a subtle way. It made cheap stocks cheaper, expensive stocks more expensive, while leaving overall equity prices relatively unchanged. The effect was invisible to an observer of the overall market or someone studying just a few stocks, but became more and more clearly visible through the lens of diversified long–short quant portfolios.
In early August, a number of quant equity investors started running for the exit and things escalated in the week of Monday, August 6. All my long-term research was put aside as I was staring at the P&L screen, wondering what to do about it. The P&L updated every few seconds, and I saw the losses constantly mounting. Here was a real-life liquidity spiral, all too similar to that in my theoretical model. It is difficult to explain the emotional reaction to seeing many millions being lost, but it hurts. It hurt even though the strategies that I had worked on were actually unaffected and even though I had a tenured lifetime appointment at NYU to return to. It has been said that you cannot explain what it is like to be in a war unless you experience bullets flying over your head, and I think something similar holds for being in the midst of a trading crisis. I understand why most of the successful managers whom I interviewed for this book emphasize the importance of self-discipline.
The question that kept going through my head was “what should we do?” Should we start selling part of the portfolio to reduce risk but then contribute to the sell-off and reduce the potential gains from prices turning around? Or should we stay the course? Or add to our positions to increase the profit from a future snapback of prices? Or rotate the portfolio to our more secret and idiosyncratic factors that were not affected by the event? Although I was engaged in these important deliberations as an academic with models of exactly this type of liquidity spirals, let me be clear that I wasn’t exactly running the operation. I suspect that there was a sense that I was still too much an academic and not enough a practitioner, akin to Robert Duvall’s character in The Godfather, Tom Hagen, who was too much lawyer and not enough Sicilian to be “wartime consigliere.”
To answer these questions, we first needed to know whether we were facing a liquidity spiral or an unlucky step in the random walk of an efficient market. The efficient market theory says that, going forward, prices should fluctuate randomly, whereas the liquidity spiral theory says that when prices are depressed by forced selling, prices will likely bounce back later. These theories clearly had different implications for how to position our portfolio. On Monday, we became completely convinced that we were facing a liquidity event. All market dynamics pointed clearly in the direction of liquidity and defied the random walk theory (which implies that losing every 10 minutes for several days in a row is next to impossible).
Knowing that you are facing a liquidity event and that prices will eventually snap back is one thing; knowing when this will happen and what to do about it is another. The answer is complex and, though this book will go into the details of the quant event and the general principles of risk management in an efficiently inefficient market, let me briefly tell you how it ended. In the funds with limited leverage, we managed to stay the course and made back most of the losses when the snapback finally started on Friday morning. In the more highly leveraged hedge funds, we reduced positions to limit the risk of a forced sale, but we started putting back the positions close to the bottom just before the market turned around. When the profits started, they arrived at an even wilder pace than the losses had.
I returned to my “peacetime” efforts of developing new trading strategies and other long-term research. I set out to understand each of the different types of trading strategies and their return drivers through careful research. I had the fortune of working with lots of great people across investment teams and helped develop new funds with elements of all the eight strategies discussed in this book, long–short equities, short-selling, quantitative equities, global macro, managed futures, fixed-income arbitrage, convertible bond arbitrage, and event-driven investment.
As I love the combination of theory and practice, I decided to straddle both worlds between AQR and academia, first at NYU and now also at Copenhagen Business School as I moved back to my home country, Denmark, after 14 years in the United States. I have been teaching a new course on hedge fund strategies that I developed based on my research and experience and the insights of my colleagues, interviewees, and guest-lecturing hedge fund managers. The lecture notes for this course slowly developed into this book.
Anyone interested in financial markets can read it. The book can be read at different levels, both by those who want to delve into the details and those who prefer to skip the equations and focus on the intuitive explanations and interviews. It is meant both as a resource for finance practitioners and as a textbook for students. First, I hope that the book is useful for finance practitioners working in hedge funds, pension funds, endowments, mutual funds, insurance companies, banks, central banks, or really anyone interested in how smart money invests and how market prices are determined.
Second, the book can be used as a textbook. I have used the material to teach courses on investments and hedge fund strategies to MBA students at New York University and master’s students at Copenhagen Business School. The book can be used for a broad set of courses, either as the main textbook (as in my course) or as supplementary reading. The book can be read by students ranging from advanced undergraduates to Ph.D. students, several of whom have gotten research ideas from thinking about efficiently inefficient markets. My website contains problem sets for each chapter and other teaching resources: www.lhpedersen.com.