For Wall Street's Math Brains, Miscalculations

Taleb believes in monkey-wrench events that shatter the models of the quant-jocks. He says their algorithms don't adequately account for huge, rare anomalies, such as the current surprise credit crunch. Or the Russian credit crisis in 1998 that nearly put the superstar quant fund of the time, Long-Term Capital Management, out of business in a matter of days, saved by cash infusion organized by the Federal Reserve.

The sentiment is reminiscent of the demise of Enron, a company said to have been designed by geniuses but run by idiots. The oil-and-gas trader used next-generation financial tools designed by brilliant mathematicians. But they couldn't overcome the inept and criminal actions of the management.

The allure of a unifying, perfect mathematical formula is powerful; it is an alchemy for the enlightened age. Math's universal principles underlie and suffuse everyday life and the workings of the cosmos, offering a glimpse of the eternal. In the frequently irrational financial markets, mathematic models offer the hope of cool reason and certitude, a sort of godlike wisdom.

In the 1998 film "Pi," a troubled math genius who sees patterns in the newspaper stock tables tries to create the Algorithm for Everything. He and his work are simultaneously hunted by a Wall Street firm that seeks its predictive powers, and by orthodox Jews, who believe it could unlock the mind of God.

The quant funds thrive on volatility -- it's how they make their profit margins. But recent weeks have proved too volatile for some of the funds, many of them highly leveraged, which seemingly all at once got spooked into seeking liquidity. When they ended up seeking liquidity by selling the same stocks, the Aug. 9 plunge happened, analysts speculate, resulting in the Dow's second-largest one-day slump of the year.

"It became increasingly transparent that many of the highly sophisticated quant funds employed similar investment approaches and held similar core holdings," Thomson Financial wrote in an analysis of the role of the 25 largest quant funds in the market meltdown. "This resulted in the funds selling similar long stocks and covering similar short positions."

For instance, the most broadly held stock among the top quant shops, Thomson reported, is Exxon Mobil. Shares of the oil company dropped 2.4 percent in heavy trading during the Aug. 9 sell-off.

"If you ask the question, 'Did the smart guys blow it or get it right?' I think the answer is, if they knew it, it wouldn't have happened," said David Levine, a vice president in corporate advisory services at Thomson.

"I occasionally hear broad statements like, 'This just shows computer models don't always work,' " Clifford S. Asness, founding principal of the quant-fund firm AQR Capital Management, wrote to his clients after the sell-off. "That's true, of course, they don't, nothing always works. However, this isn't about models, this is about a strategy getting too crowded, as other successful strategies both quantitative and non-quantitative have gotten many times in the past, and then suffering when too many try to get out the same door."

The value of Simons's $29 billion Renaissance Institutional Equities Fund fell by nearly 9 percent from the beginning of the month through the Aug. 9 drop, Bloomberg News reported. It was less of a hit than many of the other quants took, possibly reinforcing Simons's status as the Dumbledore of the quants.

A mathematician and cryptanalyst, Simons headed the math department of the State University of New York at Stony Brook, pushing the program into the nation's elite.

Simons and his colleagues work in a form of high math decipherable to a handful of humans on the planet. As such, practitioners of the rare mathematic arts can become the powerful priests of investing, thanks to their strange and obscure language, much the way the medieval church trafficked in Latin, which required the translation of a learned cleric.

In 1978, Simons began to apply his predictive models to investing and set up his investment shop on the north shore of Long Island near his old school, virtually insulated from Manhattan's financial district. He generally recruits mathematicians and programmers, not MBAs and traders.

The press-shy Simons would not comment for this article, and a Renaissance spokesman could not be reached for a comment.