From www.opalesque.com Charles B. Krusen, partner at Alpha Equity Management LLC / Copernicus International LLC and 130/30 fund manager, sent Opalesque the following observations on the recent market volatility and the quantitative strategies. [...]Where do we go from here? We believe that the current volatility will subside over the next few months. We believe that the correlation between factors will revert to the mean. Quantitative managers are hard at work to introduce new sets of factors and adjust models to avoid this type of systemic event in the future, but it is a certainty that disruptions like this will occur again. When new instruments are introduced to the market (in this case, CDO and CDS), markets will often grow to the point of excess (subprime mortgages packaged as AAA), seeding the grounds for an often violent correction. This does not mean that the products are necessarily flawed; some simply need specific parameters, others should not exist. The period after the correction is characterized by: * a better understanding of the process involved (October 1987: the use of portfolio insurance /delta hedging the put option) * an appreciation for international liquidity flows (Summer 1997: the Asian Contagion/current account deficits and short term money flows) * the proper position sizing and leverage (1998 LTCM/leverage and prime broker lines) * and added transparency into accounting issues (2001-02 Enron, WorldCom). Market participants have known for a long time that the rating agencies were behind the curve and, in some instances, were asking the very investment banks whose structure they were rating to use their models to analyze the risk. Speaking of letting the fox guard the chicken coop! There will be a period of time to restructure the subprime market, but it is a manageable exposure - $1.5 trillion. A political solution similar to a RTC (Resolution Trust Corporation *) is certainly a realistic option as we approach an election year. Central to the integrity of the financial markets is the restructuring of the rating agencies and specifically addressing conflicts of interest. Basel II encouraged banks to focus on rated paper and a return to more fundamental credit analysis will be needed. In summary, we believe that, in hindsight, this will prove to be an excellent time to allocate capital to those quantitative strategies that have produced alpha on a consistent basis over time. (* Resolution Trust Corporation: A corporation formed by U.S. Congress in 1989 to replace the Federal Savings and Loan Insurance Corporation and respond to the insolvencies of about 750 savings and loan associations. As receiver, it sold assets of failed S&Ls and paid insured depositors. In 1995 its duties, including insurance of deposits in thrift institutions, were transferred to the Savings Association Insurance Fund.)[...]