Inside the Black Box: The Simple Truth About Quantitative Trading

10.4. CONTAGION, OR COMMON INVESTOR, RISK

The newest member of the quant-specific risk family is contagion, or common investor, risk. By this we mean that we experience risk not because of the strategy itself but because other investors hold the same strategies. In many cases the other investors hold these strategies as part of a portfolio that contains other investments that tend to blow up periodically. The first part of this risk factor relates to how crowded the quant strategy in question is. A second part relates to what else is held by other investors that could force them to exit the quant strategy in a panic, sometimes called the ATM effect. In an ATM effect, significant losses in one strategy cause liquidation of a different, totally unrelated strategy. This happens because investors who have exposures to both, especially if highly levered, reduce their liquid holdings in the face of financial distress and margin calls, since their illiquid holdings are usually impossible to sell at such times. In essence, the good, liquid strategy is exited to raise cash to cover the losses of the bad, illiquid strategy.

This is a particularly challenging type of risk that is certainly not exclusive to quants. However, the clarity with which this risk expressed itself in both August 1998 (easily argued not to be a quant event) and August 2007 (clearly a quant event) demands specific attention. In August 1998, it was not quant trading that suffered but other strategies such as merger ...