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Hedge Funds and the Subprime Crisis: a French Answer to French Criticism

Noël Amenc 

European leaders, eager for an explanation absolving them of responsibility, have
once again laid blame on the seemingly detrimental role played by hedge funds in
this summer's crisis. This crisis is the result of a sudden fall in asset prices,
combined with increased aversion to risk on the part of investors.

To suggest that hedge funds are to blame for this crisis is simplistic but tempting,
as their speculative, unregulated, and opaque nature make them easy targets-all the
while, more delicate market and regulatory issues are avoided. So, as a counterpoint
to these accusations that often come from France, it seemed necessary to us to
provide a French perspective on the lessons to be learned with respect to financial
regulation in France.

Lesson one: hedge funds are not responsible for the current financial crisis

The sharp fall in value and the temporary illiquidity of asset-backed securities,
commercial paper secured against high-risk mortgages supplied by subprime lenders,
has sparked a crisis of confidence that quickly spread to the credit market as a
whole, going so far as to affect the market for investment grade corporate bonds. It
is hardly possible to deplore the lack of information about the risk exposure of
hedge funds and, at one and the same time, to publish precise data on the
asset-backed securities held by these very hedge funds.

Investment in hedge funds makes up less than five percent of total institutional
investment, and strategies with high exposure to credit risk account for twenty
percent or less of assets invested in hedge funds, so it is hard to believe that all
transfers of credit risk (in 2006, in the US market alone, $4.6 trillion worth of
securitised debt, derivatives, claim transfers on secondary markets, and other debt
instruments was issued) could have been done with hedge funds alone as
counterparties.

The problem is that banks, not hedge funds, have been affected by excessive
investment in asset-backed securities and in structured credit products that have
turned out to be illiquid and that those banks have thus appeared insolvent to their
counterparties in the money market. So it is the most heavily regulated institutions
in the world--institutions whose new capital rules (Basel 2) were presented three
years ago as the result of reflection on the lessons learned from the financial
crises of the previous two decades, especially with respect to credit risk-that have
required the intervention of central banks on a massive scale.

It is, in any case, hard to imagine central bankers' coming to the rescue of
"speculators" and running the risk of increased moral hazard.

Lesson two: the crisis is linked not to underregulation but to over-regulation

The use of credit derivatives has been subject to codes of conduct as well as to
both domestic and international regulation. So the funds that have symbolised the
subprime crisis in France are those that respected the rules on the use of credit
derivatives put in place in 2003 by the Autorité des Marchés Financiers (AMF). In
fact, the crisis of confidence in the financial information reported by lenders was
caused by the unexpected halt by a major bank in the valuation, subscription, and
redemption of so-called dynamic funds. So it was caused not by unregulated parties
or by forbidden or murky practices but by regulation that failed utterly to take
into account the major risk of illiquidity that goes along with the default risk
traditionally associated with credit instruments.

As it happens, French and European regulations that attempt to define rules for the
eligibility of assets and the classification of investment funds are a failed
approach to the protection of investors and to the resolution of the problems posed
by asymmetric information, goals that justify regulatory intervention. Regulators
would do well to settle for a smaller but more effective role. One possibility, for
example, would be for regulators to replace an approach linked to classifications,
to enforcement of the rules of risk management, or to the certification of aptitudes
for investment in particular financial instruments (credit derivatives, alternative
investments, and so on)-an approach that is at best inefficient and at worst
deceptive-with requirements for information on the risk factors these funds are
exposed to, requirements that would thus facilitate the risk analyses as well as the
work on classification done by investors and rating agencies. Trying to protect
investors from themselves, without the means to do so, is probably the greatest risk
of regulation.

Lesson three: regulation in the works will increase the risk of market illiquidity

New accounting standards (IFRS) and insurance industry rules for risk management
(Solvency II), which ban volatility and penalise risk-taking, will have two
consequences.

The "better" of the two will dissuade investors from taking risks. From a
microeconomic point of view, the assumption is that insurance policyholders will pay
far higher premiums in order to continue enjoying current levels of service. From a
macroeconomic point of view, this approach will lead to the disappearance of
institutional investors capable of taking risks, a phenomenon that will discourage
equity capital investment and, more generally, lead to the creation of a rentier
economy with disastrous social consequences.

The "worse" consequence is that the financial industry will attempt to skirt these
rules through risky financial engineering. This summer's crisis is but an early
warning.

Conclusion

EDHEC's brief paper is the first phase in the larger work EDHEC plans to do on the
crisis in regulation. We believe that by preferring information requirements, codes
of conduct, and certificates of aptitude to modest but justified solutions to the
problems of information asymmetry encountered by suppliers of financial products and
investors, regulatory authorities--having relieved investors of the burden of
seeking information on the risks of their investments and fostered an illusion of
confidence that reinforces moral hazard-are complicit in the increase of this
asymmetry.

________________________________

From: EDHEC Risk Newsletter [mailto:return-newsletter@edhec-risk.com]
Sent: Friday, September 21, 2007 6:33 AM
To: Fulginiti, Michael
Subject: EDHEC-Risk Newsletter September 2007

EDHEC-Risk Newsletter

September 2007

Asset Management Research

EDHEC Alternative Indexes: August 2007 (Estimates) 

Conv. Arb.
<http://news.edhec-risk.com/070921n/indexes/pure_style/conv_arb/strategy_view> 

-1.54%

CTA Global <http://news.edhec-risk.com/070921n/indexes/pure_style/cta/strategy_view> 

-0.99%

Dist. Sec.
<http://news.edhec-risk.com/070921n/indexes/pure_style/distressed/strategy_view> 

-1.05%

Emg. Mkts
<http://news.edhec-risk.com/070921n/indexes/pure_style/emerging/strategy_view> 

-2.63%

Eq. Mkt Neut.
<http://news.edhec-risk.com/070921n/indexes/pure_style/market_ntl/strategy_view> 

-0.82%

Event Driven
<http://news.edhec-risk.com/070921n/indexes/pure_style/event_driven/strategy_view> 

-1.40%

Fix. Inc. Arb.
<http://news.edhec-risk.com/070921n/indexes/pure_style/fix_inc/strategy_view> 

-0.28%

Global Macro
<http://news.edhec-risk.com/070921n/indexes/pure_style/global_macro/strategy_view> 

-1.47%

L/S Equity
<http://news.edhec-risk.com/070921n/indexes/pure_style/long_short/strategy_view> 

-1.62%

Merger Arb.
<http://news.edhec-risk.com/070921n/indexes/pure_style/merger/strategy_view> 

0.29%

Rel. Value <http://news.edhec-risk.com/070921n/indexes/pure_style/value/strategy_view> 

-0.56%

Short Selling
<http://news.edhec-risk.com/070921n/indexes/pure_style/short/strategy_view> 

1.22%

FoF <http://news.edhec-risk.com/070921n/indexes/pure_style/fof/strategy_view> 

-2.07%

Events

Alternative Betas & Hedge Fund Replication Seminar, New York
<http://news.edhec-risk.com/070921n/AIeducation/Alternative%20Investment%20Seminars/HF_Replication_New_York>

Lhabitant Hedge Fund Seminar, London
<http://news.edhec-risk.com/070921n/AIeducation/Hedge%20Fund%20Training/Hedge%20Fund%20Training>

MiFID and Best Execution Seminar, London
<http://news.edhec-risk.com/070921n/AIeducation/Alternative%20Investment%20Seminars/mifid_and_best_execution>

EDHEC Alternative Investment Days 2007
<http://news.edhec-risk.com/070921n/events/EAID2007/index_html?newsletter=yes> 

Commodities Week Europe 2007
<http://news.edhec-risk.com/070921n/events/other_events/Event.2007-04-16.0904?newsletter=yes>

European Financial Management 2008 Symposium on “Risk and Asset Management”
<http://news.edhec-risk.com/070921n/events/edhec_conferences/Event.2007-09-12.5044?newsletter=yes>

Books

MiFID: Convergence towards a unified European capital markets industry
<http://news.edhec-risk.com/070921n/research_news/books/RISKBook.2006-11-07.5945?newsletter=yes>

EDITORIAL 

Hedge Funds and the Subprime Crisis: a French Answer to French Criticism
<http://news.edhec-risk.com/070921n/edito/RISKArticleEdito.2007-09-17.4732?newsletter=yes>
 European leaders, eager for an explanation absolving them of responsibility, have
once again laid blame on the seemingly detrimental role played by hedge funds in
this summer’s crisis. This crisis is the result of a sudden fall in asset prices,
combined with increased aversion to risk on the part of investors. To suggest that
hedge funds are to blame for this crisis is simplistic but tempting, as their
speculative, unregulated, and opaque nature make them easy targets - all the while,
more delicate market and regulatory issues are avoided. More…
<http://news.edhec-risk.com/070921n/edito/RISKArticleEdito.2007-09-17.4732?newsletter=yes>

INDUSTRY ANALYSIS 

EDHEC replies to the European Commission on MiFID
<http://news.edhec-risk.com/070921n/latest_news/featured_analysis/RISKArticle.2007-09-17.5738?newsletter=yes>
 In response to a letter from the European Commission on EDHEC’s position paper,
“MiFID: the (in)famous European Directive?”, EDHEC have reiterated that there are a
number of issues that may threaten the fairness of the market upon the demise of the
concentration rule currently prevailing in many member states. These issues are
related to three aspects of the Directive that are supposed to act as counterweights
to the consequences of the likely fragmentation of the market: the post-trade
transparency obligation; the pre-trade transparency obligation; and best execution.
More…
<http://news.edhec-risk.com/070921n/latest_news/featured_analysis/RISKArticle.2007-09-17.5738?newsletter=yes>

Property derivatives and the hedging fallacy
<http://news.edhec-risk.com/070921n/site_edhecrisk/public/latest_news/featured_analysis/RISKArticle.2007-09-17.4539?newsletter=yes>
 Property derivatives have been promoted as a revolutionary tool for real estate
portfolio risk management, Frédéric Ducoulombier of the EDHEC Risk and Asset
Management Research Centre argues that this is a misguided approach that obscures
the key benefits of these instruments. More…
<http://news.edhec-risk.com/070921n/site_edhecrisk/public/latest_news/featured_analysis/RISKArticle.2007-09-17.4539?newsletter=yes>

FEATURES 

EDHEC survey shows that professionals agree with the conclusions of a study on the
shortcomings of stock market indices
<http://news.edhec-risk.com/070921n/features/RISKArticle.2007-09-17.4725?newsletter=yes>
 A recent publication by the EDHEC Risk and Asset Management Research Centre has
drawn conclusions that highlight the shortcomings of well known capitalisation- or
price-weighted stock market indices and argues that the choice of benchmark for
asset allocation or performance measurement is a task requiring particular care. In
a call for reactions to this publication, EDHEC finds that the answers of the more
than eighty respondents (asset management firms, pension funds, insurance companies,
private banks, etc.) tend to reinforce the conclusions drawn by the original
publication. More…
<http://news.edhec-risk.com/070921n/features/RISKArticle.2007-09-17.4725?newsletter=yes>

INTERVIEW 

Interview with Dominic O’Kane
<http://news.edhec-risk.com/070921n/Interview/RISKArticle.2007-09-17.2156?newsletter=yes>
 In this month’s interview, we discuss credit risk, credit modelling and the initial
risk management lessons to be learned from the subprime crisis with Dominic O’Kane,
affiliated professor with EDHEC Business School. More…
<http://news.edhec-risk.com/070921n/Interview/RISKArticle.2007-09-17.2156?newsletter=yes>

RESEARCH NEWS 

An Analysis of Hedge Fund Strategies
<http://news.edhec-risk.com/070921n/site_edhecrisk/public/research_news/choice/RISKReview.2007-09-13.2437?newsletter=yes>
 Daniel P.J. Capocci. The aim of this analysis of hedge fund strategies is to
understand how managers make or destroy value. Capocci has developed a multi-factor
performance and persistence analysis model and used it over several time periods. He
also analysed the neutrality of hedge funds against equity markets in order to
validate hedge fund managers’ claims that they are market neutral. Finally, he
developed new efficient frontier measures, which not only include returns and
volatility, but also skewness and kurtosis in order to determine whether hedge funds
are really beneficial to investors. More…
<http://news.edhec-risk.com/070921n/research_news/choice/RISKReview.2007-09-13.2437?newsletter=yes>

Active Versus Passive Index Management: A Performance Comparison of the S&P and the
Russell Indexes
<http://news.edhec-risk.com/070921n/research_news/choice/RISKReview.2007-08-27.1254?newsletter=yes>
 S. Gowri Shankar. Gowri Shankar notes that not all index funds can be considered
passively managed funds since stock indices themselves are constructed and
maintained in different ways. According to Sharpe’s (1991) definition of a passive
index, the Russell indices, which are constructed solely on the basis of their
market capitalisation, are passively constructed, while the S&P indices are actively
constructed by an index committee at Standard & Poor’s that chooses firms using
discretionary criteria. Nevertheless, these indices are typically considered
substitutes, despite the differences in their construction. More…
<http://news.edhec-risk.com/070921n/research_news/choice/RISKReview.2007-08-27.1254?newsletter=yes>

International Equity Indices: Exploring Alternatives to Market Cap-Weighting
<http://news.edhec-risk.com/070921n/research_news/choice/RISKReview.2007-08-27.5653?newsletter=yes>
 Olfa Hamza, Mohamed Kortas, Jean-François L’Her, Mathieu Roberge. In this article,
the authors take note of the criticism of the cap-weighting systems used by
international equity indices and seek the best weighting system for these indices.
To that end, they construct hypothetical indices of the MSCI EAFE countries (over
the period from 1970 to 2000) to examine the relative performance of the weighting
schemes of the MSCI EAFE index. The authors examine the effectiveness of
GDP-weighting and equal-weighting as solutions to the over-concentration inherent to
cap-weighting. They note that no specific model in portfolio theory supports
GDP-weighting. More…
<http://news.edhec-risk.com/070921n/research_news/choice/RISKReview.2007-08-27.5653?newsletter=yes>

EDHEC PUBLICATIONS 

The Amaranth Collapse: What Happened and What Have We Learned Thus Far?
<http://news.edhec-risk.com/070921n/edhec_publications/all_publications/RISKReview.2007-09-06.3327?newsletter=yes>
 Hilary Till. On September 18th, 2006, market participants were made aware of a
large hedge fund’s distress. On that date, Nick Maounis, the founder of Amaranth
Advisors, LLC, had issued a letter to his investors, informing them that the fund
had lost an estimated 50% of their assets month-to-date. By the end of September
2006, these losses amounted to $6.6-billion, making Amaranth’s collapse the largest
hedge-fund debacle to have thus far occurred. More…
<http://news.edhec-risk.com/070921n/edhec_publications/all_publications/RISKReview.2007-09-06.3327?newsletter=yes>

Revisiting the Limits of Hedge Fund Indices: a Comparative Approach
<http://news.edhec-risk.com/070921n/edhec_publications/all_publications/RISKReview.2007-09-18.3950?newsletter=yes>
 Noël Amenc, Felix Goltz. Hedge fund indices have been criticised for a lack of
representativity and for their biases, to the point that serious doubts about the
usefulness of hedge fund indices have been raised by investors and regulators. This
paper examines whether the problems that are outlined for hedge fund indices also
exist for other indices that seem to be widely accepted. The drawbacks of hedge fund
indices pointed out in the literature do indeed exist. However, in this paper, the
authors point out that there are possible solutions to these problems. More…
<http://news.edhec-risk.com/070921n/edhec_publications/all_publications/RISKReview.2007-09-18.3950?newsletter=yes>

EDHEC-RISK NEWS 

EFM Association and EDHEC Business School jointly organising symposium on Risk and
Asset Management in Nice (17-19 April, 2008)
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-13.5306?newsletter=yes>
 On 17-19 April, 2008 in Nice, France, EDHEC Business School and the EFM Association
are jointly organising the European Financial Management 2008 Symposium on Risk and
Asset Management. The keynote speaker at the event will be Richard Roll, UCLA. The
call for papers is open and all papers accepted for the symposium will be eligible
for publication in a special issue of European Financial Management. More…
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-13.5306?newsletter=yes>

CFA Institute approves EDHEC as provider of professional development programmes
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-18.5403?newsletter=yes>
 EDHEC Asset Management Education (EAME) has been admitted as an Approved Provider
under the CFA Institute Professional Development (PD) Programme. The decision by the
leading association of investment practitioners means that pre-approved executive
education courses offered by EAME will be considered “safe harbour” professional
development activities for the 91,000+ CFA Institute members worldwide. More…
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-18.5403?newsletter=yes>

CAIA designation accelerates growth
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-18.2614?newsletter=yes>
 Against the backdrop of record institutional investments into private equity, hedge
funds, real estate, commodities, and derivatives, the number of candidates for the
Chartered Alternative Investment Analyst® designation jumped 73% to 4,274 in 2007.
Sponsored by the not-for-profit CAIA Association®, the charter attests to an
individual’s mastery of the concepts, tools and practices essential for managing
alternative vehicles. More…
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-18.2614?newsletter=yes>

EDHEC holding seminar in London on MiFID and Best Execution (18-19 December, 2007)
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-13.4331?newsletter=yes>
 EDHEC is organising a two-day seminar on 18-19 December 2007 on the topic of MiFID
and Best Execution. The aim of the seminar is to offer a practical understanding of
the directive’s impact on business and on the wider asset management industry, and
to provide a roadmap for compliance with new operational requirements, together with
the conceptual and practical tools to set up the processes to achieve and
demonstrate best execution. The seminar is designed and delivered by academic and
industry specialists, Catherine D’Hondt and Jean-René Giraud. More…
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-09-13.4331?newsletter=yes>

EDHEC organises Alternative Betas and Hedge Fund Replication Seminar in New York (16
October, 2007)
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-07-06.0652?newsletter=yes>
 Following the official presentation of the results and conclusions of its latest
research into hedge fund replication at a seminar in London on 28 June, EDHEC is
organising a new session, the Alternative Betas & Hedge Fund Replication Seminar, in
New York on 16 October where Lionel Martellini will present a novel approach to
hedge fund investing and detail the associated techniques for identifying,
measuring, and optimizing the beta benefits of hedge funds. More…
<http://news.edhec-risk.com/070921n/about_us/news/RISKArticle.2007-07-06.0652?newsletter=yes>

Lhabitant Hedge Fund Seminar, Oct 16, London
<http://news.edhec-risk.com/070921n/AIeducation/Hedge%20Fund%20Training/Hedge%20Fund%20Training>

Copyright EDHEC-Risk©2007 - Legal Terms & Privacy
<http://news.edhec-risk.com/070921n/privacy>

============================================================================ 

Goldman Global Alpha Fund Fell 22 Percent in August (Update1)

2007-09-13 04:15 (New York)

(Adds performance of Red Kite and Old Lane funds in ninth

paragraph.)

By Jenny Strasburg and Katherine Burton

Sept. 13 (Bloomberg) — Goldman Sachs Group Inc.’s Global Alpha 

hedge fund fell 22.5 percent in August, its biggest monthly decline, 

on losses from currency and stock trades, according to an update sent 

to investors.  The fund, managed by Mark Carhart and Raymond Iwanowski, 

has dropped by a third in 2007 and 44 percent from its peak in March 

2006. Investors notified New York-based Goldman last month that they 

plan to withdraw $1.6 billion from the fund, or almost a fifth of 

the assets as of July 31.

Goldman Alpha’s biggest loss in the month stemmed from the managers’ 

decision to sell Japanese yen and buy Australian dollars. The 

so-called carry trade unraveled when the Australian dollar fell 6 

percent against the yen in August. The managers’ investment in 

equities, including stocks in the U.S., Norway and Finland, declined 

4.7 percent. “With losses this large, typically you have to look at 

the return potential going forward,” said Gregory Dowling, vice 

president for alternative investments at Cincinnati-based Fund 

Evaluation Group LLC, which doesn’t have money in the Goldman fund. 

“If there isn’t a possibility of a snap-back, you have to examine 

where else you can put that capital.” Carhart and Iwanowski, both 41, 

use mathematical formulas to select trades, known as quantitative 

investing. Goldman injected $2 billion into Global Equity Opportunities, 

another quant fund run by the pair, after it lost 28 percent in the first 

eight trading days of August. The fund, which also received $1 billion 

from outside investors, rose 12 percent in the following week.

Fundamental Beliefs “We still hold our fundamental investment beliefs 

that sound economic investment principles coupled with a disciplined 

quantitative approach can provide strong uncorrelated returns over 

time,” Goldman said in the unsigned report.  Goldman spokeswoman 

Andrea Raphael declined to comment.  Hedge funds are largely unregulated 

investment pools that can bet on falling as well as rising asset prices. 

Their managers gain substantially from profits on money invested.

The 22 percent decline in Global Alpha compares with the 20 percent drop in 

Red Kite Metals, the world’s largest hedge fund dedicated to metals. Old Lane LP, 

the hedge-fund firm acquired two months ago by Citigroup Inc., lost 5.9 percent 

in August, quadruple the industry’s average decline, as bond and emerging 

markets fell.  Global Alpha will have to return 80 percent before the managers 

can resume collecting 20 percent of the fund’s investment profits from clients who 

were in the fund at the beginning of last year.

`Quant Managers’ Other quant managers fared better in August after a rocky start. 

James Simons’s $29 billion Renaissance Institutional Equities Fund made up 

the entire 8.7 percent loss it suffered in the first eight trading days of August.

Goldman blamed its losses on too many quantitative funds making the same trades, and 

said in mid-August it would have to develop new strategies.  “Longer term, successful 

quant managers will have to rely more on unique factors,” Goldman’s fund-management 

division said in a report to clients. “While we have developed a number of these 

factors over the last several years, in hindsight we did not put sufficient weight on 

these relative to more popular quant factors.”

–Editor: Edelman (scc/tbq)

To contact the reporters on this story:

Katherine Burton in New York at +1-212-617-2335 or kburton@bloomberg.net; Jenny Strasburg in New York at +1-212-617-1518 or jstrasburg@bloomberg.net

To contact the editor responsible for this story:

Larry Edelman at +1-617-210-4621 or ledelman3@bloomberg.net

[TAGINFO]

=========================================================================================

AUGUST AMBUSH
How Market Turmoil Waylaid the 'Quants' 

Morgan Stanley Star Is
Among Those Battered;
No Time for Music Now 

By SCOTT PATTERSON and ANITA RAGHAVAN
September 7, 2007; Page A1 

Peter Muller, a 43-year-old trader at Morgan Stanley
<http://online.wsj.com/quotes/main.html?type=djn&symbol=ms> , is used to
markets behaving more or less as he expects. But in late July, some
unusual patterns perplexed him. Certain investing strategies that
historically had posted steady gains started faltering for no evident
reason. 

Soon, the unusual trading spread from U.S. to Japanese and European
markets as well. Mr. Muller picked up rumors that one or more unknown
investors were buying and selling giant positions similar to the ones he
held, according to someone familiar with the matter. The next two weeks
proved one of the biggest convulsions ever faced by a breed of market
players that includes Mr. Muller: quantitative investors, known as
“quants.” 

 These traders use complex mathematical models to invest in markets
around the globe. Their computers track a wide range of data and
variables, such as how cyclical stocks do when a particular currency
rises or falls. Formulas programmed into their computers spit out prices
at which stocks or other instruments are to be bought and sold. In fact,
the computers themselves often do the trading. 

Quant strategies have been around for decades, but in recent years they
have really come into their own, thanks in part to technology that has
lowered the costs of their trading-intensive methods. Whereas investors
like Warren Buffett and Peter Lynch defined an era of common-sense
“value” investing in the 1980s — and swashbuckling hedge funds betting
on everything from metals to the British pound typified the 1990s –
quants have scaled the heights of the investing world in the past
decade. 

Quants’ avoidance of the limelight has only amplified the aura of stars
like James Simons of Renaissance Technologies Corp. and David Shaw of
D.E. Shaw Group. Large investors such as pension funds seek the steady
returns these funds have produced. Assets in just two common types of
quant funds — known as “statistical arbitrage” and “market neutral”
funds — have risen nearly 60% in two years, to $96 billion as of June
30, according to research group Hedgefund.net. The rise reflects both
investment gains and new money. 

Against this backdrop, quant funds’ turmoil in late July and early
August was all the more disconcerting. The broader U.S. stock market
fell about 4% in that stretch. But Renaissance Institutional Equities
slid 8.7%. Another big quant fund, AQR Capital Management, lost 13%. A
Goldman Sachs Group Inc. quant fund called Global Equity Opportunities
fell about 30%. Tykhe Capital LLC saw losses of roughly 20%. And Mr.
Muller suffered along with them. 

Though few on Wall Street know about it, his group at Morgan Stanley has
been among the investment bank’s most profitable operations in recent
years. Known as PDT, for Process Driven Trading, it produced profits of
roughly $3.5 billion in the 10 years through 2006, people familiar with
it say. They add that PDT, which now contains about $6 billion of Morgan
Stanley’s money, accounted for 7.2% of the bank’s net income last year
by producing $540 million in profits. 

But between the last week of July and Aug. 9, PDT lost approximately
$500 million, according to traders. Neither Morgan Stanley nor Mr.
Muller would comment on the losses or on PDT’s trading strategy. Morgan
Stanley said it is fully committed to the quantitative trading business. 

“It’s a very humbling event for [quants] to take these kinds of losses.
These guys think of themselves as masters of the universe,” said Lee
Maclin, manager of Pragma Financial Systems, a New York “fund of funds,”
or hedge fund that invests in other hedge funds. 

The quants’ summer woes remind some of the near-meltdown almost a decade
ago of high-flying hedge fund Long-Term Capital Management. Like quant
funds, LTCM was steered by brainy academics who made money exploiting
out-of-kilter relationships between different securities. Unlike LTCM,
though, today’s quant funds are far less leveraged and thus unlikely to
sustain huge losses as LTCM did. 

Quants say their bad patch will be forgotten as their strategies
continue to churn out steady profits. Most of the funds, including Mr.
Muller’s, have recouped some of the losses. By the end of August, AQR
had bounced back by roughly 10% from its lows, and the Goldman fund by
12%, according to people familiar with these funds. 

Even so, the outsize drops could dim the luster of the quant approach –
especially since quants themselves still don’t know for certain what
triggered the carnage. A common theory is that one or more large funds
was forced, possibly because of losses on subprime mortgages in other
parts of its business, to rapidly dump stock to raise cash, and this set
off a ripple effect among quant traders. Others say that stocks that
were expected to fall began rising when traders who had borrowed shares
and sold them were forced to start buying shares back. Meanwhile, the
proliferation of quant funds holding a lot of the same positions may
have been a recipe for magnifying the losses. 

Mathematical, computer-driven trading was an arcane corner of the
financial industry when Mr. Muller joined Morgan Stanley in 1992. He had
been exposed to it, however, for several years at Barra Inc., a
risk-analysis firm in Berkeley, Calif. 

A 1985 math graduate of Princeton, Mr. Muller impressed some investment
elders early on. Jeremy Grantham, chairman of the big money-management
firm GMO LLC, recalls seeing a youthful Mr. Muller as a panelist at a
conference 20 years ago. “I caught both super-quants [on the panel] in a
logical fallacy,” Mr. Grantham says. “The first one kind of choked on
it, but Peter danced around the minefield like a tap dancer. I thought,
‘That guy can really think on his feet.’ ” 

Restless after Barra went public in the early 1990s, Mr. Muller
interviewed for a job at Morgan Stanley. He told executives there that
he didn’t really think any amount of money could get him to leave his
laid-back California life for Wall Street. But he accepted when the bank
offered to let him set up a group that would invest some of its own
money using a quantitative strategy. 

Morgan Stanley — which eventually bought Barra — wasn’t new to such
techniques. Years earlier, it had employed Nunzio Tartaglia, a onetime
astrophysicist and Jesuit seminarian who was an early practitioner of a
particular quant strategy. And one of Mr. Tartaglia’s underlings in the
1980s was Mr. Shaw, now the proprietor of one of the largest quant
funds, D.E. Shaw. 

The strategy Mr. Tartaglia used gives an idea of how quants operate.
Called “pairs trading,” it involves betting on two stocks that have a
strong historical relationship. 

Suppose that General Motors and Ford Motor stocks usually move more or
less together. If they aren’t doing so at a particular time, and there
is no clear reason why, there’s a good chance the past relationship will
reassert itself. So if Ford has risen while GM languished, a quant might
buy GM shares and sell Ford short, betting on it to decline. The “pairs
trade” will pay off if the historic correlation returns. 

Quants play the game on a massive scale — betting on many different
securities and using borrowed money to magnify the effect of any market
anomalies detected by their computers. So although they expect to lose
on many trades, the gains tend to outweigh the losses, thanks to their
formulas and computing power. Ideas like pairs trading have blossomed
into others such as “statistical arbitrage,” a more complex version that
is one of Mr. Muller’s specialties at PDT. 

By the late 1990s, PDT group had become so successful it commanded the
biggest chunk of Morgan Stanley’s stock trading for its own account. Mr.
Muller let members of the group dress down when their returns were up –
and forced them to dress up when their returns were down — so everyone
else at the firm knew how they were doing. 

But according to a short biography on Mr. Muller’s Web site, he “woke up
6 years ago and realized that he can no longer find happiness in the
corporate world.” He had already taken a one-year 1999 sabbatical. In
2001, he left full-time work again, though he remained an adviser.
Friends say Mr. Muller felt he had already accomplished more than he
expected, and the intense money focus and social-climbing side of New
York left him wishing for a more balanced life. He also had broken up
with a longtime girlfriend. 

 So over the next several years, Mr. Muller traveled to Bhutan, New
Zealand and Hawaii, and kayaked in the Grand Canyon. He spent time in
California and took up yoga. He began writing crossword puzzles, several
of which appeared in the New York Times. 

He also became more serious about his music. He had taken up the piano
as a child and joined a jazz band in California. In 2002 and 2004 he
recorded albums on his own label, Dog and Hammock Productions. During
his time away from Morgan Stanley early this decade, he could be seen
playing on the streets of Barcelona, Spain, and in New York City
subways. 

Mr. Maclin of Pragma Financial recalls seeing Mr. Muller playing on a
subway platform: “People were dropping change in his [keyboard case] not
realizing the guy is worth millions.” 

Late last year, Mr. Muller returned to Morgan Stanley full time,
encouraged by Chief Executive John Mack’s push toward more aggressive
risk-taking at the investment bank. The trader also felt that in what
was becoming an increasingly competitive quant field, PDT could benefit
from more hands-on guidance. 

Though secretive about their formulas, quants like him are often seen
together at social gatherings. Poker is a favorite pastime. Mr. Muller
is the ace of the group. While away from Morgan Stanley, he briefly
joined the World Poker Tour and pocketed nearly $100,000 in a tournament
in 2004. 

In March 2006, at a charity event called Math for America held at New
York’s St. Regis Hotel, several quants squared off in “Wall Street
Poker” night. Looking on, according to people who were there, was a
murderers’ row of hedge-fund managers: Citadel Investment Group’s
Kenneth Griffin, Renaissance Capital’s Mr. Simons and David Einhorn of
Greenlight Capital Inc. In the final round, Clifford Asness, who runs
AQR Capital, faced off against Mr. Muller, who took the title with a
pair of kings to his foe’s ace and 10. 

This summer was less fun. Mr. Muller had retaken the helm of PDT just in
time for the biggest test of his career, as the subprime-mortgage
meltdown broadened into a more-general credit squeeze. Among the unusual
results was that stocks many investors considered low-quality — and had
bet against — began to outperform the market, says Diane Garnick,
investment strategist at Invesco PLC. She attributes much of this to
“short covering”: Investors who had borrowed shares and sold them had to
buy them back when their brokers reined in their credit lines. In
contrast to the “flight to quality” often seen during a crunch, she
says, the anomalous result was a “flight to non-quality.” 

The phenomenon may have been magnified by the similarity of quants’
portfolios. Their world is one of shared theories. “Everybody has read
the same academic literature and knows what’s in the air,” says Richard
Bookstaber, a portfolio manager at FrontPoint Partners. Mr. Asness, in a
letter to his investors at AQR, wrote that the early-August jolt “is
about a strategy getting too crowded.” 

Mr. Muller has been playing detective to avoid repeating past mistakes,
peppering friends with questions about the performance of his peers,
asking pointedly which funds got in trouble and which did better, says a
person familiar with the situation. He has talked several times with Mr.
Asness. 

Though computers execute quant trades, real people are constantly at the
switch during the trading day, monitoring portfolios to make sure the
programs are operating according to plan. If a computer accumulates too
much of a single stock, a trader may intervene. And quants are always
tweaking their models. Mr. Muller has told friends that the August swoon
presents opportunities for experienced managers like him. 

Then there’s his music. Songs on his first two albums reflected what was
going on his life, including one song with the lyrics “I almost made my
escape, I almost got away…. So hard to quit when you’re good at the
game.” 

But Mr. Muller’s Wall Street career is getting in the way again. Since
returning to PDT, he hasn’t written a new song all year. As he recently
wrote on his Web site, “one of my other passions, mathematical finance,
has taken a lot of my time this year.” 

Write to Scott Patterson at scott.patterson@wsj.com and Anita Raghavan
at anita.raghavan@wsj.com