The Quants

The Quants is a lively and accessible introduction to the mathematicians, physicists, and various other geeks who, as the subtitle puts it, “conquered Wall Street and nearly destroyed it.” Written by Wall Street Journal staff reporter Scott Patterson, The Quants has enough technical detail to satisfy students of the hedge fund world, but its storytelling momentum is strong enough to carry those who are mostly interested in the plot.

Patterson makes his job more difficult by focusing not on any one prototypical quantitative investor but on several: Peter Muller of PDT, Ken Griffin of Citadel Investment Group, Cliff Asness of AQR Capital Management, and Boaz Weinstein of Deutsche Bank. All are described as brilliant and secretive, and all seem to have been inspired by Ed Thorp, whose two books Beat the Dealer and Beat the Market made the mathematical connection between success at Twenty-One and success in the stock market.

By seeking out previously unnoticed patterns and arbitrage opportunities in the financial markets, the new generation of investment geeks seized power from the “Big Swinging Dicks” of the 1980s, the testosterone-fueled traders who succeeded with nerve and gut instincts. A symbolic changing of the guard came when the quants devised a way to beat the Big Swinging Dicks at their trademark game of Liar’s Poker. The BSDs accused them of cheating, but the game quietly went away.

If the quants didn’t have the same swagger as their predecessors, they succumbed to their own brand of hubris: the belief that their sophisticated models didn’t simply capture temporary inefficiencies in the market but that they represented The Truth. ("Beware of geeks bearing models,” said Warren Buffett.) Once they had been created, some of the models worked brilliantly for extended periods of time, generating millions of dollars with no apparent effort.

Until they didn’t. The quants failed to recognize the full risk of what Nassim Nicholas Taleb described as a Black Swan: an unpredictable event with a massive impact. And they failed to realize just how irrational people and markets could be. The classic quote attributed to John Maynard Keynes does not appear in this book, but sums it up well: “Markets can remain irrational longer than you can remain solvent.”

Though the quants and their models can’t bear all the blame for the market meltdown of 2008 (and the hedge fund meltdown that preceded it), they must accept some of it. And the last few pages of The Quants are not reassuring.

There were legitimate concerns that as computer-driven trading reached unfathomable speeds, danger lurked.

Many of these computer-driven funds were gravitating to a new breed of stock exchange called “dark pools”—secretive, computerized trading networks that match buy and sell orders for blocks of stocks in the frictionless ether of cyberspace.... In these invisible electronic pools, vast sums change hands beyond the eyes of regulators. While efforts were afoot to push the murky world of derivatives trading into the light of day, stock trading was sliding rapidly into the shadows.

Increasingly, hedge funds had been crafting new systems to game the pools, hunting for price discrepancies between them in the eternal search for arbitrage or even causing price changes with dubious tactics and predatory algorithms. Hedge funds were “pinging” the dark pools with electronic signals like submarines hunting prey, searching for liquidity. The behavior was largely invisible, and light-years ahead of regulators.