Man vs. Machine on Wall Street: How Computers Beat the Market

He went off to the University of Pennsylvania and entered a dual-degree program in computer engineering and finance. He signed up for the LSATs but switched to the GMATs after his father convinced him that "people who can actually do math and engineering probably shouldn't be lawyers." He built a computer and wrote operating systems in FORTRAN. For extra cash, he worked for a few Wharton professors who wanted him to "code up" and test their theories. To his surprise, the task turned into more than just a job. He became engrossed by the idea of using computers to analyze stocks. He decided to pursue economic and finance theory in a doctoral program at the University of Chicago, under the professors Eugene Fama and Ken French. (Fama is considered a father of the "efficient-market hypothesis"--the increasingly controversial idea that because at any given time the prices of stocks trading in the market reflect all the available public information about them, the market is "efficient" and therefore tough to beat.)

While there, Asness wrote academic papers on subjects like "Changing Equity Risk Premia and Changing Betas Over the Business Cycle and January," and slowly absorbed the principles that would become the bedrock of both his financial strategies and his political discourse. He wrote his thesis on the "puzzling trait" of winning and losing stocks to keep winning or keep losing, even when data suggested they had overshot their true value in one direction or the other. He thus became one of the earliest theorists on momentum investing, which AQR still uses to its advantage by shorting stocks that seem to be on a momentum-fueled bender.

Meanwhile, Asness's best friend from college, Jonathan Beinner, went to Goldman Sachs to work in its asset--management business, known as GSAM, then a backwater at the firm. In 1992, Beinner asked Asness to come work for the summer at GSAM in the fixed-income division, building quant models. "It was very low-cost, low-risk to them," Asness said. While there, he developed inchoate versions of what he still uses at AQR to choose stocks, bonds, and currencies. At the end of the summer, Goldman asked Asness to stick around in the asset-management program for another year. "I was really on the fence between going back to academia versus taking it," he continued. "I was writing my dissertation at night." But the money Goldman offered him--about $100,000 a year--quickly changed the calculus, and he accepted. At GSAM, he specialized in trading mortgage--backed securities. "It was a great baptism," he wrote in a 2007 essay, "as every investing disaster that can befall you happens to some variety of a mortgage--back in reasonably short order." (He apparently learned his lesson: while mortgage-backed securities played a huge role in the market crash in 2008, they played no direct role in AQR's problems at the time.)

After reading a paper he wrote about models and steep bond-yield curves, which Asness wryly called "a page-turner," an executive at PIMCO, the huge asset manager, offered him a job starting a new quant-investing group. When he told his boss at Goldman about the offer, his boss said that GSAM was starting its own quant group and asked Asness to stay and run it. This would be a genuine "present-at-the-creation 
moment," when Asness and his team would combine for the first time the exponentially growing power of computers with the academic theories he had learned from Fama and French, along with his own pioneering thinking on momentum investing. A new long-term-investing strategy had been born, and it quickly proved very successful.

By then Asness had recruited John Liew and Bob Krail--two former classmates at Chicago--to come to Goldman and join him. In 1994, the first assignment for the new quant group was to investigate whether models could help stock pickers evaluate risk in foreign countries, where Goldman's asset-management team had a poor record. Using their proprietary models, they bought stocks in countries whose markets were undervalued and sold stocks in countries whose markets were overvalued. "It turned out that the value-and-momentum strategy for picking countries performed quite well," Asness wrote in the essay. In their youthful enthusiasm, they published their findings in an academic journal, effectively giving the milk away. (They quickly learned not to do that. Publishing current findings would be "a capital offense" at AQR, he said.)

Asness and his team soon replicated that success by creating models for buying bonds and currencies. He persuaded Goldman to start a hedge fund, using partners' money to employ his quant strategies. In short order, the team turned the partners' $10 million grubstake into $100 million. Goldman then opened the fund, named Global Alpha, to outside investors, with the pitch "You get the Goldman secret sauce with this smart team," Asness recalled. The fund was a rocket ship, up 111 percent in 1996 and 42 percent in 1997. By that time, they were managing $7 billion in total.

Despite a promise from Hank Paulson, then Goldman's No. 2, that he would soon become a partner at the firm, Asness started to feel the lure of starting his own hedge fund with Liew and Krail, free of Goldman's bureaucracy and compensation restraints (which likely would have put a lid on his annual income in the $10 million-to-$20 million range, far below what top hedge-fund managers make). The catalyst for their departure from Goldman was probably the single--mindedness of David Kabiller, whose job at the time was to meet with chief investment officers of pension funds and endowments and persuade them to let Goldman invest their money. Kabiller was convinced that he and the Chicago boys could create something special. "We can have more fun," Kabiller told them. "We can be more unfettered."

One of the problems at Goldman was that the firm would not leave the men alone to just manage the $7 billion--their first love--and kept after them to mentor others and to provide quant tools and analyses for the marketing department. "We were a support group as well as an asset-manager group," Asness explained. The final straw came one night when Kabiller was on a blind date with a woman whose father, a big hedge-fund manager, was going to invest in a fund being started by one of their recently decamped Goldman colleagues, who the team thought was a mediocre investor. In the middle of the date, Kabiller called Asness and told him how outrageous this seemed. "We had a feeling like, 'Gee, are we gonna be the guys sitting in IBM and watch this entrepreneurial guy go and leave and become really successful?' " Kabiller said. The departure process lasted a year. "Of agonizing," Asness said.

Finally, in early 1998, the four men left Goldman to start Applied Quantitative Research. By August, AQR had raised a $1 billion hedge fund, thought to be one of the largest initial hedge funds of all time, only slightly smaller than the one raised by the infamous Long-Term Capital Management, which opened in February 1994 with a group of star bond traders from Salomon Brothers and two Nobel laureates. This was a time when the allure of hedge funds of many different stripes--not just quantitative hedge funds--was growing across Wall Street. Physicists and mathematicians were fleeing academic departments to enter finance. Goldman was losing alpha males convinced of their own investing prowess. Hedge funds were cultivating an air of invincibility. Nerds were suddenly cool, and everywhere. (One hedge-fund manager I spoke with recalled working next to a group of quants in his office and thinking to himself, "This is the geek tank. They were behind glass. They had their headsets on all day, just computer programming.") According to Lo, the MIT professor, the number of quant-style hedge funds grew from something like 50, in January 1994, to nearly 700 by the peak in 2007.

As it happened, AQR had started just months before Long-Term Capital blew up (and needed to be rescued), and in the midst of the Internet bubble, when anything related to the Web seemed to double or triple in price overnight. It was a world of irrational momentum, an environment that could not have been worse for Asness's investing style. In 1999, AQR owned a bunch of seemingly undervalued stocks, in businesses like banking and manufacturing, while holding short positions on seemingly overpriced tech stocks. The firm was getting killed, bringing to mind Keynes's famous observation that the market "can stay irrational longer than you can stay solvent."

Within AQR's first 20 months, its $1 billion fund was reduced to $400 million. The firm was near complete collapse, but Asness fought hard to keep it alive. He added to his value investments as the bubble inflated and kept his short positions in place, with the hope that he could capitalize when it popped. He met repeatedly with investors, and argued that he would be proved correct once the hysteria subsided. And indeed, things soon turned around. From 2000 to 2002, in a bear market, AQR "made a ton of money," Asness said, and then for the next few years "made decent money" in a generally bull market. The firm nearly lost it all again in the August 2007 fiasco, and suffered along with everyone else during the financial crisis the following year. But because AQR was now more diversified--with products ranging from mutual funds for small investors to a variety of funds available only to sophisticated institutional investors--the threat to its existence was not nearly what it had been in 1999.

Then, in the past two years, AQR roared back, thanks to both a near-doubling of the Dow from its nadir in March 2009, and a return to the efficacy of the long-term-investing strategies Asness had pioneered since his days in academia. With that success, of course, came a return to confidence for him and his firm.

Next page: The future belongs to hedge funds

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William D. Cohan, a columnist for BloombergView, is a contributing editor at Vanity Fair and the author, most recently, of The Price of Silence.

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