The test was a big “If” – and hedge funds failed
By John Authers, Investment Editor
Published: September 14 2007 15:10 | Last updated: September 14 2007 15:10
Rudyard Kipling famously wrote that "if" you can keep your head when all about you are losing theirs and blaming it on you, “you’ll be a Man, my son”.
Hedge fund managers conspicuously failed Kipling’s virility test last month. Their quantitative models lost their heads while others kept theirs. And now, everyone is blaming the summer’s equity volatility on them.
This is no longer a case of “When in doubt, blame it on a hedge fund”. Rather, it is now possible to piece together who bought and who sold in August. There is a persuasive case that hedge funds contributed to the volatility, and maybe even created it.
A few horror stories have already filtered out. Some hedge funds, of course, collapsed altogether after investing in investment vehicles closely tied to subprime mortgages.
More intriguing were the accidents for diversified funds, which suffered losses primarily in equity and foreign exchange markets – sectors that should be only tangentially affected by the turmoil in credit.
Goldman Sachs’ Global Alpha hedge fund fell 22.5 per cent in August, and has lost a third of its value for the year. It faced demands for redemptions of $1.6bn as it entered August, and went on to make unsuccessful bets on the yen to weaken against the Australian dollar, while the value of its equities fell.
There is now evidence that many other hedge funds suffered similar fates, and that this led the market’s volatility last month.
Jeff Shacket of Thomson Financial pieced together an analysis of buyers and sellers of the 30 stocks in the Dow Jones Industrial Average using the records kept by custodial banks – the institutions that hold securities on behalf of fund managers – for the weeks up to August 16.
To recap: the Dow sold off amid panic in late July, then bounced in the first week of August from about 13,250 to 13,650, before turning down once more, and entering into capitulation selling on August 16, before suddenly rebounding. On that day, the Dow opened and closed at 12,850, having touched a low at noon of 12,500.
It turns out from Thomson’s analysis that hedge funds drove the sell-off in late July, and continued to sell aggressively in August. They increased the pace of their selling to nearly $2bn during the first week (when the market rebounded), and redoubled that pace during the second week.
Looking at what the hedge funds sold, they tended to sell outperformers aggressively in early August, unloading more than $2.3bn of the Dow stocks that had done well through to May.
At the same time, they bought underperformers, buying more than $500m.
When the market tanked once more, however, they sold winners and losers uniformly: $2bn of each.
So after desperate taking of profits in “winners”, they tried to get out of the market altogether – just in time for it to rally.
It turns out that the buying that fuelled August’s first rally came from companies themselves, who were taking the opportunity to buy back their own stock at cheap prices, and hence boost earnings per share. They bought about $4bn in the first week.
Meanwhile, retail investors – those who invest directly over the internet, as well as “country club” investors who do so through their brokers – stayed on the sidelines. So, broadly, did institutions, such as mutual funds.
So who were the heroes who led the buying on the afternoon of August 16? The Thomson analysis shows that it was retail investors who kept their heads while all about them lost theirs. They pumped $1.7bn back into the Dow during the second week of August, having sold steadily for the previous 10 weeks.
This was a market-timing bet, rather than an attempt to buy value. They invested in low-yielding stocks, which tend to benefit most from a general market bounce, rather than in obviously cheap stocks with a high yield.
Yield did matter, however, to the suddenly desperate hedge funds. They sold low-yielding stocks aggressively, dumping $4bn of them, and holding on to the Dow stocks with the highest yields.
So retail investors charged in, buying “aggressive” stocks that might bounce back the most; hedge funds got out of the market, skewing the holdings they retained to more defensive stocks that were less likely to go down.
So far, of course, we know who has been proved right. Retail investors have made money out of the panic in the hedge-fund world.
Hedge funds were in a mess – probably because their quantitative models had gone haywire – and bailed out desperately.
But who will be proved right in the long run? It is not clear that the retail investors truly kept their heads. Rather, they made a big market-timing bet. Over history, this style of investing can lose you a lot of money. They also made a big implicit bet that the Fed would do what the market wanted, and cut rates.
That history is yet to be written. Next week’s Federal Reserve meeting will be the next big test. Who will keep their head the next time all about them lose theirs?
john.authers@ft.com
Copyright The Financial Times Limited 2007 |
