In essence, AQR is betting that markets will revert to the mean, and that investors will act "rationally" once information about individual companies is fully digested. (As an
example, he said he recently declined Goldman Sachs's invitation to invest in Facebook at a $50 billion valuation, which he considered excessive.)
Quants sometimes speak about having found the Holy Grail of investing, the ability to construct vast portfolios of stocks that are nearly perfectly hedged--bets on value on one side, bets against momentum on the other--and that they believe should be, over the long haul, relatively immune to the market's increasingly violent vicissitudes. Scott Patterson refers to this phenomenon as the belief that they have discovered "The Truth." "Quants will say, 'No, we don't believe anything like that.' But actually when you sit down with them over a couple drinks, they'll start talking like that," he explained. "It's this belief that it's all captured in mathematics and models."
While quant investing remains a relatively small part of the financial world--perhaps $500 billion now, according
to eVestment Alliance, out of the tens of trillions of dollars invested worldwide--in their effect on professional investors, the quants punch well above their collective weight, because what they're doing is considered so cutting-edge. Firms like D. E. Shaw, Renaissance Technologies, and Barra attract waves of Ph.D.s eager to create models that might lead to the next great investing technology, and to personal fortunes. Other investors can't help but take notice and try to emulate them.
Next page: "Potentially devastating consequences"
Sometimes, though, the quants get too clever for their own good, with potentially devastating effects. Such a moment occurred in the second week of August 2007, when a wave of selling by a group of quant funds using the same trading strategies led to terrible losses, as the firms all tried to sell the same stocks at the same time. As Andrew Lo, a professor at MIT's Sloan School of Management, observed in a September 2007 paper on the event, an "apparent demand for liquidity" that week "caused a fire sale liquidation." Patterson estimated that AQR lost $500 million in a single day, and close to $1 billion in the four-day rout before the markets steadied and started to recover on August 10.
(AQR doesn't dispute this estimate.) "No one really knows how much money was lost over this one-week period," he said. "But I've heard estimates that $100 billion evaporated out of these quant funds. It could be more, it could be less. No one ever really knows."
Things were so bad, in fact, that AQR, which was pursuing an initial public offering, soon dropped the idea. "They knew these strategies worked and they deluded themselves into thinking that they would always work," Patterson said. "And that's a very dangerous way of looking at the world, because it allows you to take more risks. That's why I think the quants sort of represent the entire financial system in a way. They got blinded by science."