Book Review: The Quants

As an employee in a moderate sized financial services firm whose pruimary clients are hedge funds, Scott Paterson's "The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It" is an extremely entertaining read on the topic.  The industry has gotten progessively more complicated as brilliant math students graduated from top-class colleges and began gathering capital for their strategies.  The book vaguely discusses the different quantitative investment funds including AQR, Rennaissance Technologies, Citadel Group, Deutsche Banks' SABA and Morgan Stanley's PDT fund, and all of its key personel. 

It opens with a discussion of Ed Thorp, whose interest in investment was sparked by his passion for arbitrage opportunities in gambling, but went on to create the first convertible bond arbitrage fund.  This strategy focuses on pricing inefficiencies between common stock and derivatives, warrants in Thorp's case.  The strategy encourages shorting the overvalued of the pair, while simultaneously going long on the undervalued of the pair.  As the inefficiency is detected by other market participants it will converge and Thorp would make money as equilibrium returned.  Losses would be hedged because both securities would likely move in tandem.

The most important thing for Thorp's strategy was risk management.  He understood that many of his wagers had only a 55% chance of success, which seems small, but over the long term can be infinitely profitable.  However, the % of capital invested in each position has a direct impact on the risk of ruin due to short term bad luck.  He discovered the Kelly criterion, which he used in his blackjack strategy was an appropriate tool for determining "bet sizes."  Many believe the crash was a result of firm making wagers of a size far higher than Kelly would suggest, by used leverage.  The profitability of these strategies has fallen as more particpants understand and enter the market, but even if all positions had a 60% chance of success, a short term down swing from equilibrium can easily cause a devastating loss if the bet size is too large.

My only critiques of the book were that it was not techincal enough for my tastes as an insider, but I believe the level of sophistication and detail was appropriate for an outsider.  Also many of the story lines felt a little overly fantastic, although not neccessarily exagerated by the author.  I felt a lot of the parallel story lines were recycled and I believe the layout of content had room for improvement.

I really enjoyed mention of the poker influence on the industry including mention of famed degenerate TJ Cloutier and Jen Harmon.  Tales of high living such as "models and bottles" are always nice as well!

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