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Dec 1, 2010 The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed ItScott Patterson
2010 Crown Business $27.00 hb 352pp
This past summer I spent the long US Independence Day weekend at a reunion with three of my undergraduate classmates. All of us went on to earn PhDs in physics, but I am the only practising physicist. The others work in finance – one at a hedge fund, the other two at major banks. They all seem to be enjoying their work, and they have obviously been very successful: our reunion took place near a famous ski resort, where one of the financiers has built a 1200 m2 retreat complete with gym, indoor pool and wine cellar.
Even the brightest graduate students in maths and physics know that their chances of assuming a position like that of their PhD supervisors are slim. For the last 20 years the cream of the crop of physicists leaving the field has gone on to positions in finance, typically in places such as New York or London. Once there, these individuals become hedge-fund managers, derivatives traders and risk managers, to take just a few examples from my own cohort.
So what do these people do? I have always been surprised that scientists in academia are not more curious about the lives of their former peers working in the "real world". For those who are interested, Scott Patterson's The Quants does an admirable job of exploring the increasingly mathematical and technological world of high finance, and the activities of the many physicists, mathematicians and engineers who inhabit it.
Patterson writes for the Wall Street Journal, and regular readers of the newspaper will recognize him as an insightful reporter who has covered a number of important topics over the years, most recently the rise of high-frequency trading. In researching the book, Patterson had access to a Who's Who of prominent "quants", a colourful group of characters with backgrounds and personalities that will be strangely familiar to anyone who has spent time among physicists. The term "quant" is short for "quantitative" and refers to those who apply mathematical or computational methods to finance.
Patterson begins by introducing the reader to ideas ranging from the basics of modern finance theory, such as efficient markets and random walks, to more esoteric topics such as the late Benoît Mandelbrot's use of Lévy distributions, or Gaussian copula and their role in the mortgage meltdown. It is worth noting that Patterson focuses primarily on proprietary trading and hedge funds, while spending much less time on the derivatives business or structured finance, two other areas where quants tend to be employed.
All this information makes an effective backdrop to the book's main story: the August 2007 quant-fund collapse that presaged the mortgage meltdown and subsequent global financial crisis. Patterson chronicles in detail how losses in the mortgage portfolios of banks and hedge funds forced them to sell off liquid assets such as the "vanilla" stocks (those of large Standard & Poors 500 companies) typically traded by large quant funds. This unanticipated deviation from the behaviour of financial models – in particular the wave of fear and paranoia that quickly spread among traders – led to huge losses for the quant funds. One prominent fund, Process-Driven Trading, lost $500m in a single month. This episode reminds us of the central role that human psychology – what the economist John Maynard Keynes called "animal spirits" – plays in markets, rendering them ultimately resistant to mathematical prediction.
To highlight the human element in this tale of financial collapse, Patterson includes many sketches of prominent quants. Among these, Ed Thorpe deserves Patterson's description as the godfather of quants. An academic mathematician who became famous in 1962 for his statistical analysis of the card game blackjack (recounted in his classic book on card counting Beat the Dealer), Thorpe later became one of the earliest and most successful hedge-fund managers. The similarities between games such as blackjack or poker and modern finance are significant: strategies in each can be refined through mathematical analysis, but success is ultimately still dependent on luck and the ability to manage risk.
Perhaps the most successful of all quants is Jim Simons. In the early 1970s Simons was a graduate student of the mathematician Shiing-Shen Chern at the University of California, Berkeley. I doubt he was a physics student, as Patterson states, although Chern–Simons theory does play an important role in theoretical physics. In 1978 Simons left academia in favour of finance. Today, the Renaissance Technologies hedge funds he set up employ mainly former scientists, including mathematicians, physicists and statisticians, and its Medallion Fund boasts consistently positive returns that are unequalled by any other fund. Simons attributes this to his employees' training in science, having once told the Wall Street Journal that "the advantage scientists bring into the game is less their mathematical or computational skills than their ability to think scientifically. They are less likely to accept an apparent winning strategy that might be a mere statistical fluke."
Among the younger quants profiled, Peter Muller seems the most interesting. An idealist who was frequently conflicted about his career in finance, Muller built the Process Driven Trading (PDT) group at Morgan Stanley, which at one point in the late 1990s accounted for a quarter of all profits for the entire firm. During this period, he would sometimes jet off to the Hawaiian island of Kauai for some hiking, leaving his lieutenants and algorithms to manage PDT's multi-billion-dollar financial positions. Like many of his fellow quants, Muller is an avid poker player, but he is also a musician who occasionally performs in the New York City subway and has released two CDs.
The broader financial crisis that followed the quant-fund collapse is not the major focus of this book. Readers seeking a deep discussion of its causes and consequences should look elsewhere. From my own investigations, I would say that while quants played an important role in the crisis, their influence was secondary to other causes, such as a housing bubble, misaligned incentives within banks and imprudence on the part of government-sponsored entities such as Fannie Mae and Freddie Mac, which provided funding for countless high-risk mortgages.
But that does not absolve quants entirely. It is a pity that although Patterson gives us a broad survey of quant finance, he devotes little space to the bigger question: are developments such as the mathematization of markets and the flow of top brains to financial activities good for society? On this matter, perhaps it is best to leave the last word to Charlie Munger, the long-time investment partner of financial guru-in-chief Warren Buffet. Writing in 2006, Munger had the following to say about the "brain drain" of top talent into finance.
"I regard the amount of brainpower going into money management as a national scandal. We have armies of people with advanced degrees in physics and math in various hedge funds and private-equity funds trying to outsmart the market. A lot of…older people…can remember when none of these people existed…At Samsung, their engineers meet at 11 p.m. Our meetings of engineers [meaning our smartest citizens] are also at 11 p.m., but they're working on pricing derivatives. I think it's crazy to have incentives that drive your most intelligent people into a very sophisticated gaming system."
Steve Hsu is professor of theoretical physics at the University of Oregon, a founder of two Silicon Valley software start-ups and author of the blog Information Processing
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