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October 4, 2007

Quantifying Volatile Markets

By Gregory Bresiger

Sometimes quants and their models fail, says Chris Erfort, head of equity trading at Twin Capital Management, a quant fund outside Pittsburgh. Erfort, who is also the firm's portfolio manager, says August's volatile markets were a prime example of panic selling.

A hedge fund with $750 million in U.S. equities, Twin Capital has two strategies: a long-only fund and a long/short fund. Erfort says many quants were misled by models during August's violent market downturn. Their models and benchmarks failed them because of unusual market occurrences.

These markets "made trading difficult," he says. Managers using the usual yardsticks suddenly found themselves holding the wrong stocks because models underestimated short-term risk. Once the market tanked, inexperienced managers, blindly following models, fled to cash. They missed the market's comeback.

Erfort believes there is an inherent risk in all quantitative investing: All models, no matter how good, have limitations. "These models can underestimate their risk, especially after periods of low market volatility," he says. Why? Say, for example, the market goes through a four- or five-year period of low volatility. Then there is a one-year period of high volatility. In the short term, the model won't reflect the one-year blip.

Nevertheless, Erfort says his firm's risk controls, not using leverage and knowing how to use its models, allowed it to sidestep much of the market bloodshed in August. He employed various trading strategies by adjusting his level of trading aggressiveness: He either lengthened or shortened the time of a trade when stocks were moving in his favor.

"This is one example of how a trader can add value by knowing what algorithms to use and when to be aggressive and passive." The firm gained 80 basis points in August. The Credit Suisse/Tremont Hedge Fund Index was down 1.53 percent in the same month. Erfort, who concedes that the early part of the month was difficult, says he can contain risks because he's not looking for big double-digit returns. "When someone gets huge returns you have to ask how much risk did someone take to get 50 percent or better returns?" he says.

Sometimes quants get outsize returns by using a model that makes big bets. A portfolio might have only 15 stocks, he says. In Erfort's long/short strategy, he'll generally have at least 70 to 90 stocks on each side. He believes diversification ensures that clients achieve conservative goals.

For example, Twin Capital's Momentum long/short fund returned 7.91 percent a year net of fees in a five-and-a-half year period ending in July. Certainly not spectacular, but it is what his risk-averse institutional clients want, Erfort argues. Twin Capitals' clients are primarily pension funds, but only a few are individuals. Individuals often have unrealistic goals, he says.