A pair of academics at MIT have published a paper that seems to confirm the Rothman Theory of this summer’s Quant Bloodbath. The Rothman Theory—named for Lehman Brothers analyst Matthew Rothman who laid it out in a note published in the midst of the blood bath—held that the initial quant fund losses were triggered a large hedge fund unwinding one or more market-neutral portfolios.

Now Amir E. Khandani and Andrew W. Lo have used financial models to simulate this summer’s bloodbath, and what they found largely confirms the Rothman Theory.

The findings are likely to be welcomed by the quants, who are still smarting from what they think was biased reporting about their troubles this summer. Their findings suggest that the quantitative nature of the losing hedge funds was incidental, and the main driver of the losses in August 2007 was the firesale liquidation of similar portfolios that happened to be quantitatively constructed. That firesale was likely set-off by a hedge fund facing margin calls or seeking to pre-emptively reduce risk after its credit portfolio was hit by this summer’s collateral and credit crunch.

You can see why this is appealing to the quants. The math magic still works! It’s was just those 25-standard deviation moves triggered by subprime. How were the funds supposed to know they were all following the same strategy? This is why the Rothman Theory was so popular with quants to begin with.

But the quants might not like the conclusions the egg-heads draw. Their findings also suggest that hedge funds may have grown more dangerous since the demise of Long-Term Capital Management in 1998, according to Portfolio magazine’s Odd Numbers blog. Part of the problem is that long-short equity hedge fund returns are increasingly correlated. What’s more, the finding that the source of this summer’s long-short bloodbath seems to lie in a completely unrelated set of markets and instruments—the credit market—suggests that systemic risk in the hedge-fund industry may have increased in recent years.

Hedge funds are becoming more like banks, and the reason that the banking industry is so highly regulated is precisely because of the enormous social externalities banks generate when they succeed, and when they fail. Unlike banks, hedge funds can decide to withdraw liquidity at a moment's notice, and while this may be acceptable if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector.

What Happened to the Quants in August 2007? [SSRN; link downloads pdf file]

Doomsday Clock for Hedge Funds Is Ticking [Portfolio.com]