Page 2 of 3 No such thing as a Sure
Thing By Julian Delasantellis
profitability; like the vast
majority of all investment strategies, sometimes
it'll make you money, sometimes it won't.
These types of investment strategies are
often called "value strategies" since the
underperforming stocks are said to represent good
"value".
Even if you've got a strategy
that gives you some market outperformance, there's
no guarantee that you're going to make
good
money if you get the "beta" wrong. If you could
only separate out alpha from beta, individual
stock risk from general market risk ... "Can do,
can do, this guy says the strategy can do."
If you look to find underperforming stocks
to buy, then, the logic goes, shouldn't you try to
find outperforming stocks to sell? They're above
their averages, their means, so, for them,
reverting to the mean will lead to price declines.
If you "short" sell these stocks (all "shorting
stocks" really means is that you're reversing the
normal time sequence of "buy low-sell high") in
the hopes of buying them back later so as to take
your profit, theoretically of course, you have the
perfect hedging complement to buying the
underperforming stocks. This is particularly true
as - once again, theoretically - selling the
outperforming stocks also should generate alpha.
Since these stocks have already outperformed and
outpaced the general market, they're due for a
greater than average pullback should the general
market falter.
There you have it, an alpha
generating strategy that is shielded, protected,
from general market risk, from beta. Surely, if
this wasn't A Sure Thing, what was?
"If he
says the horse can do, can do, can do."
What Lo and Khandani discovered was that
this strategy, called "long/short equity-market
neutral", was employed on a massive basis in the
period leading up to the market meltdown. In a
July 6, 2006 Asia Times Online piece, Hedge funds - playing dice with the
universe, I wrote,
Get a lot of players all doing the
same thing, putting in huge orders to buy or
sell the same instrument at about the same time,
and you can move the price of that instrument
tremendously in a short time ... On June 1 the
European Central Bank (ECB) warned of the risks
to market stability from what it called the
"correlation of hedge-fund returns" If all the
hedge funds are doing the same thing - such as
placing huge leveraged bets on the Indian stock
market, a major casualty of the post-May 11
global selloff - then all their returns will be
"correlated" or, in non-economist terms,
similar. ECB vice president Lucas Papademos
stated: "The increasingly similar positioning of
individual hedge funds ... is another major risk
for financial stability ... With all of them
investing similarly, the risks of the market
turning against their positions, resulting in a
tremendous destruction of global capital
liquidity, have also grown apace."
That appears to be exactly what
happened in August. It's not that long/short
equity-market neutral is an inherently bad, or an
inherently good strategy. It's just that, with so
much of the global wave of liquidity, the same
force that so stoked the subprime mortgage crisis,
being directed at hedge funds all taking a similar
positions, things were bound to get grim if these
positions suddenly turned bad and everybody had to
get out fast all at once. It's not that there
weren't enough exits to get out when the panic
started; it's rather that these hedge funds were
trampled to death just getting to the exits.
Lo and Khandani put it in more
academically desiccated prose. "Likely factors
contributing to the magnitude of the losses of
this apparent unwind were: the enormous growth in
assets devoted to long/short equity strategies
over the past decade."
Why did the
strategy fail? Think back to its basics, to buy
stocks that had been underperforming the market.
By July, many of the stocks that had been doing
the worst all year had been the ones most exposed
to the troubles in the US real estate sector, the
banks, the mortgage companies, the homebuilders.
If one loaded up on these stocks thinking you were
due for a bounce you were in for an unpleasant
surprise this summer. The S&P Banking stock
index lost over 13% of its value from the July
highs to August 7, the days that Lo and Khandani
centered their analysis around; the stocks of the
HBM Homebuilders ETF lost 18%. These stocks had
been weak all year; rather than revert back to the
mean in August, they instead packed up and raced
away from it like the Road Runner being chased by
Wile E Coyote.
If the laggards who got
bought got clobbered, what about the leaders who
had previously got shorted, got sold? They didn't
do all that badly; over this period the Amex XCI
technology index only declined 6.4%, and it has
now surpassed its July highs. Many observers have
noted that tech stocks and the NASDAQ did not fare
that badly during much of the August turmoil and
this is the reason: besides having minimal
exposure to the subprimes, nobody had to sell this
sector to bail out of a huge losing long/short
equity-market neutral position.
Panic
selling that arose out of these continuing and
deepening losses intensified the damage; press
reports at the time were stating that many of the
hedge funds that were utilizing these strategies
lost up to 30% of their value in a few weeks. In
essence, in mid-summer you would have been much
better off swimming at a shark infested beach
rather than of using borrowed money to take on
huge positions buying banking and real estate and
then shorting high tech.
The banking
stocks essentially bottomed out on August 3, but,
for the general market itself there was still much
hard slog to come, nine tough trading days ahead,
before the general market would bottom on August
16, the day before the first Federal Reserve
discount rate cut. Over that time the Dow Jones
Industrials would lose another 700 points, about 5
% of value.
Lo and Khandani do not look
much at this period, but, a continent away from
where it was happening at Hedge Fund Cosmopolis,
in Greenwich, Connecticut, I could feel what was
going on as it occured.
Most hedge funds
are started by, and still run by, great traders
who, for the most part, have given up trading. The
frenetic pace of modern trading is very much a
young (overwhelmingly) man's game; besides, if
you're shopping around for a hedge fund to park a
few million in, whether you're a sheikh from Dubai
or a pension official from California, you expect
to be wined, dined and schmoozed by the big name
Great Trader who started the fund, not some shiny
blow dried salesman who a month ago was selling
annuities to gingham-jumpered farm state widows.
So who's running the store down at the
hedge fund trading desks? The Great Trader has
found he must delegate this responsibility to new,
up and coming great trader wannabes.
Traders are human, they're just like
everybody else, only a lot more so. They hate to
admit that they're wrong. Research has found that,
if an investor's stock position turns against
them, they'll hold it far longer than prudent,
just so as to not have to sell out of the losing
position and admit the finality of the loss, admit
that they're wrong.
It's one thing for a
small investor to hold on too long to a 100 share
position in Countrywide Financial or some other
recent market victim; the couple of thousand
dollars of losses he takes from it might actually
eventually come to be seen as a learning
experience.
It's a whole other story when
a hedge fund trader sits by and watches as a few
billion dollars of the fund's borrowed money
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