Where Hedge Funds Go to Die
Did you feel it? Yesterday, when the Dow dropped more than 600 points? Perhaps just a mild rumbling underneath the feet? Or perhaps actual cries of anguish? Or a final, muted death moan, somewhere within the forest?
No? Well even that’s not surprising. Hedge funds do tend to die amid sounds of silence. But we’ll wager a pint that yesterday didn’t record just a single death, but more likely a few hundred deaths in Hedge Land. Because while we ourselves have maintained a bearish tilt in recent months and for 2011 have tried to leave a good bit more of assets in cash, we could not (nor were we ever likely to) foresee the pace of a selloff on a day like Monday.
And neither could many hedge funds, which is the point. We have little doubt there are many smart minds concentrated in this sector. But a price dislocation like Monday’s is still likely to leave lots and lots of smaller hedge funds – despite superior brainpower and uber-sophisticated mathematical models – in deep doo doo, having performed badly in both 2010 and 2011. The dreaded day of wholesale redemptions draws nigh.
Along with minnows a few big fish will also be trapped. In immediate upcoming weeks and months, we shall be little surprised to read in our morning papers a new expose about a spectacular blow-up. [We have no idea who and no idea in which assets, strategies and structures - though if we had to venture a guess, we'd nominate commodities.] We think global macro funds will be the most usual suspect, but in a world where excessive liquidity have forced more asset classes to correlate positively, we bet many other strategies will be caught out as well.
To win news space, these exposes are almost invariably about the larger funds. And often there is an element of rogue-trader or faulty-model or excessive hubris or somesuch element thrown in, that supposedly delivered the final fatal blow. But the truth for big funds that blow up may not be all that different than for hundreds of small funds that do as well. Their advertised superiority in investment management is generally based on the same, limited number of mathematical models and trading strategies that these managers learned earlier in their careers. Such similarity in processes means global macro managers are often bunched into the same trades because all their models are telling them the same thing. With other assets correlating closely, that means much (but not all) of Hedge Land at any single point in time probably share in common 2/3 to 3/4 of their ideas we’d guess.
And when markets surprise them, which they seem to do with greater and greater frequency in recent years, hedge fund superiority is caught out as a lie because they all get soaked at the same time. They all get soaked at once because they’re all in roughly similar trades, and all trying to exit at a time when they are the main sellers and there is no one on the other side buying. Spread the contagion to other strongly correlated assets and you have the recipe for a market meltdown.
The same logic applies to large interbank trading desks from whence many hedge fund managers sprang (leaving behind hedge fund wannabees). This is a logical way to interpret the selloff of major bank stocks. Because although Dodd-Frank is supposedly hastening the exit of proprietary trading there is still probably more proprietary exposure than exists on paper. In keeping with Buffett’s wry observation that you don’t know who’s naked until the tide washes out, all of us are probably in store for another broad viewing of naked bodies. It won’t be pornographic but it could be obscene.
And this time round developed country governments are out of money. S&P has told us so. Maybe Europeans will raid their tax-sheltered billions to tie over banks (the rich helping the rich), but that’s about it. US banks in particular will have to take their lumps the way markets intended: Fail or be taken over. And those hundreds of small and not-so-small hedge funds will simply fail.
And wouldn’t that be grand?
Short Strategy Thought
With VIX closing at 48 Monday we’re pretty sure we’re in overshoot land. As said above, we understand the wariness about banks and if you’re even more worried about the economy than we are at present, you’d probably want to steer clear of high tech names, too. But we think we’re seeing real meat-and-pototoes companies with real franchises that will be around in 2012 and 2013 and lots of cash get beat up as well. And those seem like the names we’d want to investigate first.
