Editing Statistical arbitrage (section)

==Risks==
Over a finite period of time, a low probability market movement may impose heavy short-term losses. If such short-term losses are greater than the investor's funding to meet interim margin calls, its positions may need to be liquidated at a loss even when its strategy's modeled forecasts ultimately turn out to be correct. The 1998 [[default (finance)|default]] of [[Arbitrage#The fall of Long-Term Capital Management|Long-Term Capital Management]] was a widely publicized example of a fund that failed due to its inability to post collateral to cover adverse market fluctuations.<ref>{{Cite book | title = When Genius Failed: The Rise and Fall of Long-Term Capital Management | last = Lowenstein | first = Roger | year = 2000 | isbn = 978-0-375-50317-7 | publisher = Random House | title-link = When Genius Failed: The Rise and Fall of Long-Term Capital Management }}</ref>

Statistical arbitrage is also subject to [[model risk|model weakness]] as well as stock- or security-specific risk. The statistical relationship on which the model is based may be spurious, or may break down due to changes in the distribution of returns on the underlying assets. Factors, which the model may not be aware of having exposure to, could become the significant drivers of price action in the markets, and the inverse applies also. The existence of the investment based upon model itself may change the underlying relationship, particularly if enough entrants invest with similar principles. The exploitation of arbitrage opportunities themselves increases the efficiency of the market, thereby reducing the scope for arbitrage, so continual updating of models is necessary.

On a stock-specific level, there is risk of [[Mergers and acquisitions|M&A activity]] or even default for an individual name. Such an event would immediately invalidate the significance of any historical relationship assumed from empirical statistical analysis of the past data.

=== 2007-2008 financial crisis ===
During July and August 2007, a number of StatArb (and other Quant type) [[hedge fund]]s experienced significant losses at the same time, which is difficult to explain unless there was a common risk factor. While the reasons are not yet fully understood, several published accounts{{Who|date=February 2025}} blame the emergency liquidation of a fund that experienced capital withdrawals or [[margin call]]s. By closing out its positions quickly, the fund put pressure on the prices of the stocks it was long and short. Because other StatArb funds had similar positions, due to the similarity of their alpha models and risk-reduction models, the other funds experienced adverse returns.<ref name="khandani-lo">[http://web.mit.edu/alo/www/Papers/august07.pdf Amir Khandani and Andrew Lo. ''What Happened to the Quants In August 2007?'']</ref> One of the versions of the events describes how [[Morgan Stanley]]'s highly successful StatArb fund, [[PDT Partners|PDT]], decided to reduce its positions in response to stresses in other parts of the firm, and how this contributed to several days of hectic trading.<ref>{{cite web | url=https://www.wsj.com/articles/SB10001424052748704509704575019032416477138#articleTabs%3Darticle | author=Scott Patterson | title=The Minds Behind the Meltdown | publisher = Wall Street Journal Online | date=2010-01-22 | access-date=2011-06-06}}</ref>

In a sense, the fact of a stock being heavily involved in StatArb is itself a risk factor, one that is relatively new and thus was not taken into account by the StatArb models. These events showed that StatArb has developed to a point where it is a significant factor in the marketplace, that existing funds have similar positions and are in effect competing for the same returns. Simulations of simple StatArb strategies by Khandani and Lo show that the returns to such strategies have been reduced considerably from 1998 to 2007, presumably because of competition.<ref name=khandani-lo/>

It has also been argued that the events during August 2007 were linked to reduction of liquidity, possibly due to risk reduction by high-frequency [[market maker]]s during that time.<ref>[https://ssrn.com/abstract=1288988 Amir Khandani and Andrew Lo. ''What Happened to the Quants in August 2007?: Evidence from Factors and Transactions Data'']</ref>

It is a noteworthy point of contention, that the common reduction in portfolio value could also be attributed to a causal mechanism. The 2007-2008 financial crisis also occurred at this time. Many, if not the vast majority, of investors of any form, booked losses during this one year time frame. The association of observed losses at hedge funds using statistical arbitrage is not necessarily indicative of dependence. As more competitors enter the market, and funds diversify their trades across more platforms than StatArb, a point can be made that there should be no reason to expect the platform models to behave anything like each other. Their statistical models could be entirely independent.