1987…

“It was almost like being caught in an earthquake where you’re half in shock. There’s a sense of incredible disbelief.”

For some readers, that quote may ring true for various times throughout the history of the market, but for me, it refers to October 19, 1987…also known as Black Monday. This represented the biggest single-day stock market collapse in history—a 23 percent drop.

Just 14 days prior to the crash, I had been hired by one of the country’s largest telecommunications companies, as Manager of Research for the team that managed the firm’s $6 billion in defined benefit pension assets. Prior to my arrival, our company had contracted with an external asset management firm whose objective was to actively manage the equity exposure of our pension assets via the purchase and sale of extremely ‘liquid’ equity index futures.

In the mid-1980’s our fund, as well as other large institutional asset allocators, increasingly came to rely on the risk management algorithms that were collectively known as ‘Portfolio Insurance’ strategies. Mechanically, Portfolio Insurance utilized a hedging technique that systematically sold stock index futures as the equity market declined and, in theory, resulted in the creation of a synthetic put option on the market. These Portfolio Insurance products were created to protect investors from falling markets and were sold to us on the idea that our portfolio could not suffer more than a 10% decline in value which we, in turn, communicated to our Board of Directors.

However, we were unfortunately not the only institutional investor utilizing a Portfolio Insurance strategy. When the market suddenly declined sharply on the afternoon of Friday October 16, sell signals were received and acted on by virtually all Portfolio Insurance managers across the country. The overflow of sell orders overwhelmed the capacity of traders and flowed into the open on Monday morning. As the equity market collapsed on the open on October 19, stocks declined further and faster than they ever had before. As the market’s freefall accelerated, our insurance strategy required more and more futures to be sold short to achieve the protection we had been promised. This of course, drove the market lower, which in turn required us, and all investors utilizing similar insurance strategies, to sell more futures—a self-perpetuating selling cycle for which there were very few natural buyers.


Source: Report of the Presidential Task Force on Market Mechanisms, January 1988

The night of October 19, myself, along with my team, initiated a call with our external Portfolio Insurance manager who had assembled a team of some of the best and brightest academics, strategist, and practitioners of the time. The magnitude and ferocity of the day’s events had shaken us all. We had violated our promise to our Board and had lost over $1 billion in pension assets (approximately $16 billion at today’s market levels). During this call, we were advised by our manager to continue selling thousands of futures contracts on Tuesday’s open as their model dictated. On the other hand, we could observe spreads between the futures and cash market that had never been seen before. Because of this irrational discount in the futures market, we knew that to continue selling futures would simply result in further permanent losses for the pension fund. After much debate, we made the decision to fire our external manager, abandon the synthetic put model and instead, begin buying back S&P futures on Tuesday’s open.

Over the ensuing months, we earned back hundreds of millions in lost assets. This day changed the future of the investing world and, personally, changed how I viewed quantitative models, behavioral biases, and the potential impacts of oversold and overcrowded trades.

In the aftermath of Black Monday, many legal and structural changes were implemented to reduce the risk of future meltdowns. For example, in the months following the crash, the SEC advocated for a single security that would represent the entire market and possibly increase liquidity in times of market stress. In January 1993, State Street Global Advisors launched SPY, the first U.S. ETF listed on the American Stock Exchange. This first ETF forever changed the investing landscape. Following the launch of SPY, the next ETF did not come to market for another two years. However, today, there are over 6,000 ETFs globally that invest over $6 trillion. The availability of low-cost ETF securities has fueled a massive trend toward passive investment strategies, created mounting fee pressure on both active managers and hedge funds, and has forced asset managers to compete harder, become more transparent, and attempt to produce higher and more unique alpha.

Source: State Street Global Advisors

For me personally, I learned behavioral biases and herding behavior can negatively influence the most sophisticated quantitative algorithms. I learned the indisputable value of systematic quantitative methods when applied with discipline, and in recognition of real-world trading and liquidity uncertainties. I learned the danger inherent in the blind application of mathematically sound, but ultimately unverified and misapplied trading algorithms. Finally, I learned to stand strong on principal, maintain an open and curious mind, search for bias and non-conforming results, and to continually research and investigate new ideas that seeks to deliver significant and differentiated alpha for our clients.

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