As the July performance numbers for "market neutral" hedge funds reflect 10 - 30% losses, several things are quite evident.
1) The failing of quant strategies reaches far beyond the short term black box type of market maker or day trading systems that led to unheard of drawdowns 4 weeks ago..
2) Historical backtesting shows that relative strength strategies fall flat on their face in a declining market, yet the majority of market neutral funds use relative strength as an integral factor in their pricing models.
3) The great majority of quant models failed to take into account a key variable called "liquidity". When there have been market crisis in the past, two main things happen: uncorrelated markets can become highly correlated with all markets moving down in unison. The second factor is that often the "'most highly valued" assets experience the worst decline since it is easier to hit bids in big cap blue chips or the more liquid, higher grade vehicles, then it is to try and sell junk or small caps where bids are thin. After all, cash must be raised to meet margin calls and redemptions as drawdowns steepen.
None of the 10 - 20 billion dollar hedge funds would have experienced such wretched July performance if it wasn't for that word that keeps popping up: Leverage. You can leverage a market neutral strategy out the yin yang but this does not reduce risk. It leads to even greater exposure to some type of outlyer event.
When I was a peon options floor trader, my backers (who I had to turn to after I had blown out my own account in 1982 in a takeover deal) would pull me in on a Saturday morning and give me a lecture anytime they thought that my position was too big. Their main words still ring in my ear, "It is never a problem getting into a position, it is always a problem getting out of that position when you need to."
In a prior blog, I mentioned Mandlebrot's book, "The Misbehavior of Markets". Here is another gem that a client mentioned: "A Demon of our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation" by Rick Bookstaber. This guy was preaching about how liquidity functions change asset pricing back in 1999. Thank-goodness history repeats itself or there would be no patterns at all in these markets, only sheer noise at this juncture.