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Friday, June 11, 2010

Once Again....A Down Market = Losses In Hedge Funds "Absolute Return" ? Not So Much

The volatile and negative month of May in the overall markets generated similar and often larger losses in hedge funds. Once again the claim that hedge funds are a distinct "asset class" that can provide "absolute return" generating positive results in both up and down markets has proven to be a myth. In fact rather than showing savvy in managing risk the hedge funds seemed to have been hit much worse in the "flash crash " of May 6 than indexers are conventional money managers without such active trigger fingers on the trading terminals.

The FT reports

May proves the cruelest month for hedge funds

By Sam Jones, Hedge Fund Correspondent

On May 6, days after the EU moved to implement a huge €750bn bail-out package and on the eve of the UK's knife-edge general election, traders at the world's biggest hedge funds watched as wonderland numbers flickered across their screens.

Indeed, to some hedge fund traders eyes, the way individual names moved during the now infamous May 6 movements in the Dow was disconcertingly similar to the events of August 2007 - when previously imperceptible subprime jitters in the credit markets translated into a mass computerised dumping of stocks by the giant quantitative hedge funds AQR, Renaissance Capital and Goldman's Global Alpha fund.
Though no explanation was forthcoming for the causes of the flash crash, it was, in the days that followed, painted as a freak event - idiosyncratic and technical.
Scant comfort was available for many hedge funds, though. On the Thursday and Friday of the first week of May, some lost billions.
From its newly opened offices in Geneva, traders for BlueTrend - the $10bn quantitative fund run by Brazilian financial engineer Leda Braga, saw the flagship portfolio dive 7.5 per cent - a loss of nearly a billion dollars - in the first week of May alone. BlueTrend closed May down 8.5 per cent, unable to recover.
For some funds, May was not merely on a par with, but worse than October 2008.

Reflect upon the consequence of the information above. Despite the market turmoil of October 2008 and the massive losses the hedge funds have not engaged in any strategies to reduce their exposure to sever market movements. Either they adopted new risk management strategies that failed or they simply did nothing new to manage risk.....amazing

One of my fundamental beliefs is that there are no geniuses in investing meaning managers that consistently generate market beating returns particularly when adjusted for risk. Naseem Taleeb in his brilliant book Fooled By Randomness writes of the common tendency to confuse luck with skill by making conclusions based on a very short period of manager performance. Here's a case in point:

According to Hedge Fund Research information published yesterday, the average hedge fund lost 2.26 per cent in May. Every single hedge fund strategy lost money during the month. And in many cases, it was the biggest and best-known hedge funds - such as BlueTrend - that suffered the most.
Paulson & Co - perhaps after its phenomenally successful shorting of the US subprime market in 2007 and 2008, the best known hedge fund in the world - was among those hit hard. The firm's flagship Advantage fund, which alone manages close to $7bn, closed the month down 4.8 per cent. Worst hit, however, was the manager's Recovery fund - set up in early 2009 to capitalise on the bounce back of the global economy. The $7bn fund dropped 8.7 per cent in May, though it remains up 14.35 per cent so far this year.

The hedge fund behavior in May fit the pattern we have seen repeatedly it almost reads like a textbook description: 

  1. Large leveraged positions entered into trend following trades, the trades becoming "crowded" as all the supposed geniuses of the investment world ape each others strategies.
  2. A Market shock
  3. Panic and deleveraging of the positions put on during the period of overconfidence.
  4. Large scale reversal by managers of the same positions pushing
  5.  A feedback as more and more selling generates more losses on leveraged positions and more forced liquidations
  6. Underperformance by most hedge funds compared to unleveraged investors and indices during the period of turmol.
  7. Disapointment by hedge fund investors who expected diversification and absolute return from the hedge fund "asset class" only to find their hedge fund investments simply magnified the losses on their other holdings as they were highly correlated to their other risk assets. 
The FT article describes the May action

The losses are noteworthy not so much for their size, or the concern they might have caused investors, but rather, because they caught so many off guard, and were so widespread.
The first half of the month was marked by a growing panic from many of the largest funds to delever and unwind their biggest positions. April had caught many off guard. During that month, funds had grown increasingly confident of their positions and outlook in global markets - not least as far as the eurozone was concerned. For many, April was a month to hammer home their advantage by bulking up their positions.
For macro funds, whose ambit is to trade on global economic imbalances, the eurozone's difficulties were a godsend. Funds piled into "differentiation trades" - typically short the euro, and long Asian or Latin American currencies and equities. They were undone by the size of their positions.
"As problems in Europe grew, many market participants including banks and hedge funds began to try and de-risk the other leg of their short euro trade - the large, long emerging markets positions and they all rushed out at once," says Jamil Samaha at CQS, a large London credit hedge fund.
The effect was a sudden fall in Asian markets that triggered a vicious cycle of de-risking. Losses on macro funds long-Asian plays far outstripped gains on their short-euro positions.
Some global macro funds were able to staunch the losses, others were not. Brevan Howard, Europe's largest macro hedge fund, saw its flagship vehicle down 0.7 per cent as of May 21. Paul Tudor Jones' BVI Global fund closed the month down 2.26 per cent. Moore Capital, however, saw its flagship fund lose 7.7 per cent.
"There were movements in credit during May that were greater than anything we saw after Lehmans," says a manager at one of the world's biggest credit traders. "The banks were panicked. They were marking positions to the bone and we were marking some big losses mid-month."
The effect cycled into the bond markets. Hedge funds specialising in convertible arbitrage were hit hard, according to brokers. As funds looked to hedge their risks, they bought CDS protection en masse, forcing spreads wider and only further exacerbating the cost of hedging. The only choice was to dump the underlying instruments.
In the words of one hedge fund manager, May was "a wilderness of mirrors" - when the many uncertainties and unknowns of an overstretched market became impossible to square.
What is surprising is not that the above occurred but that the story is so similar every time

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