Severe Hedge Fund Unwinding Continues
December 22, 2007
– Comments (12)
Two of the largest quantitative hedge funds each lost 6% in the month of November alone:
http://www.bloomberg.com/apps/news?pid=20601087&sid=a1u52EKp84.w&refer=home
Everyone thought these guys were using nuclear physics to magically divine alpha from an alpha-stingy market. If that were the case, then they wouldn't have similar positions and similar recent performance. Hence, their strategies must not be that complex or unique.
In my opinion, the lesson here is not that quantitative investing doesn't work. The real lesson is that crowded trades are dangerous. They're even more dangerous when you use leverage. These guys are now facing a double whammy of margin calls and investor redemptions at the same time, resulting in a vicious death spiral that cannot be overcome. When they're forced to liquidate, it means that they have to cover short positions and sell long positions which results in further negative performance. And of course, continued negative performance begets further redemptions and margin calls. The death spiral accelerates.
As a result of the hedge fund problems, "bad" stocks have been outperforming good stocks lately. Here's some evidence that I found almost shocking:
I ran a screen of all stocks with market caps between $100 million and $1.5 billion that trade on the major exchanges. That screen produced 2,919 companies. I then looked at the stock price performance of these companies over the past week (Dec 14 - Dec 21) according to short interest level. There were 841 companies with short ratios less than 3 days to cover. Their average return this past week? -- negative 0.2%. There were 596 companies with short ratios above 12x. Their average return over the past week positive 5.1%. That is a massive difference in returns. And we're not talking about small sample sizes here. This is statistically significant to a very high degree of confidence. It implies that much of the rally this past week in micro-caps was due to short covering.
This is the second time I'm making this prediction (see my August blogpost). December performance for the big quant funds will be abysmal.
So now maybe you're convinced but you're wondering, "So what? What's in it for me?" Solace and hope, for one thing. Anyone notice that many of the top Caps players seem to have been stalled out the last couple months? I think it is largely because of the hedge fund unwinding of billions of dollars of positions. This can't go on forever. Their assets have to stop at zero. I wish I knew when they were going to stop unwinding, because there would be massive profit potential in that knowledge, but I don't. I predict that when the unwinding does slow or stop, many top Caps players will resume their upward score trajectory.
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