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Friday, March 18, 2011

To err is human but to keep erring is inhuman_how a coding error blew up $217MM of a quant fund

To protect trade secrets, quantitative investment managers often isolate their complex computer models from the firm's compliance and risk management functions and leave oversight to a few sophisticated programmers. This  secretive structure and lack of oversight of quantitative investment models, may be used  to conceal errors and betray investors. That is what happened at a quant fund of AXA Rosenberg Group LLC, as outlined in this SEC complaint. 

This  institutional money manager(specialized in quantitative investment strategies) concealed from investors a material error in its computer code. The error was made in Apr-07 and eventually fixed in Jun-09. But, due to a top management directive, the CEO was not informed till Nov-09. Also, while reporting performance to clients, the model's under-performance was ascribed to market volatility rather than the error. Before the fix, clients were voicing substantial concerns about the under-performance of their portfolios, and were expressing dissatisfaction with their portfolios’ industry overexposure(a factor partly controlled by the wrong code). But this misreporting gave them a rosy picture of the firm's risk management and coding skills. This erroe happened because the firm failed to conduct sufficient quality control over the coding process before putting that model into production

So what can we learn from this incident?
  1. The need for having more audits/sanity checks on the models
  2. Disclosing your mistake(and facing risk of fund exodus) rather than being punished later
  3. In India, the applicable laws would probably not allow for restitution of investor funds as happened in this case. So Indian investors, BEWARE of investing in quant funds...

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