From an article at the GlobalSlant:
I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes, “black box” trading was very tricky. The algorithms may work for a while (even a very long while) and then, inexplicably, they’ll just completely “blow-up”. To him the most important component to quantitative trading was not the creation of a good model. The real challenge, for him, was to “sniff out” the degrading model prior to its inevitable “blow-up”. “Because, you know, eventually they all blow-up.”
As most did in August 2007. [When] years of monthly returns with exceedingly low volatility were turned “inside out” in just four to six weeks as many funds suffered monthly losses in excess of 20% which was previously considered highly improbable and almost technically impossible. Many survived but only by changing the liquidity rules to suit their own needs. [But] basically, as an investor, you could not “get out”.
Anyway, to follow up on my dialogue with the esteemed portfolio manager ... I asked, “Why do they all ‘blow-up’? And if they all eventually ‘blow-up’ then why are we even doing this?”
He answered the second part of the question first ... and I paraphrase: “We are all doing this because we can all make a lot of money before they ‘blow-up’. And after they do ‘blow-up’ nobody can take the money from us.”
As to why all these models eventually “blow-up”.
“Because despite what we all want to believe about our own intellectual uniqueness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded ... and when we all want to liquidate [these similar trades] at the same time... that’s when it gets really ugly.”
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