Hedge Funds Surviving the HFT Hurricanes?

If you've been reading my blog religiously over the last few years, you probably noticed that even though I am pro hedge funds, there's a lot more smoke and mirrors in this industry than true alpha. I've warned all my readers not to get caught up in the hedge fund hype.

A while back, Bridgewater wrote a comment on how hedge funds are selling beta as alpha. I agree, most hedge funds are nothing more than huge asset gatherers, charging 2% management fee and a 20% performance fee but adding little to no alpha. It's all beta. Just look at Long/Short Equity, one of the more popular strategies, where most managers go long small cap stocks and short large caps. Why would a sophisticated institution pay 2 & 20 for something that they can synthetically manufacture internally? If it's a niche strategy worth paying fees for, fine, otherwise, forget it.

When I trade markets, I use my knowledge of hedge funds to understand violent moves to the upside or downside. For example, when hedge funds deleverage, sell small cap stocks, you can see a massive rush out of illiquid stocks, and violent downside moves -- sometimes as much as 80% in a few days. That's why oversold can become extremely oversold, especially in the summer when people are on vacation and trading is light. Totally irrational but that's the way this wolf market operates. Great for traders, terrible for buy & hold types waiting to make a decent return on their investments.

Moreover, when hedge funds go long a sector or stock, they have position and sector limits they must adhere to, but I don't. A long time ago, I wrote a comment on why small is beautiful in this market. It is so volatile that it's better to be small and nimble, making decisions quickly, than having to be a large pension fund that has to get approval by some investment committee to take sizable opportunistic bets.

I pay attention to hedge funds. Most are wrong but the elite ones are the best of the best and unlike other asset managers, they all have skin in the game. But even they are poor market timers. I like to spy on elite funds, whether they're long-only or hedge funds, and start from there to build a portfolio of stocks across all sectors that I put on my radar list, stocks that are ripe for trading.

I also realize that when too many hedge funds own the same basket of stocks, or are on the same side of the trade, this is usually a signal to bet against them. Again, the large majority of hedge funds are awful and don't deserve an allocation. if you keep that in back of your head, you'll do fine trading these markets.

So let's take a quick whirlwind tour of what's going on with hedge funds:

• Reuters reports that August was shaping up as one of the worst months ever for some top hedge fund managers like John Paulson, but Warren Buffett may have changed that. According to Bloomberg, Paulson who is betting on an economic recovery by the end of 2012, has lost about 14 percent this month on a merger arbitrage hedge fund.
• WSJ reports when hedge-fund honchos drop their fees, sometimes they don't give their clients much of a break. Billionaire investor Paul Tudor Jones II has decided to lower some fees charged by his largest hedge fund after years of grumbling by some clients, according to people close to the matter. But Mr. Jones, who runs hedge-fund firm Tudor Investment Corp., is raising other key fees charged by the fund.
  
• One reason the high fees may not deter investors: Mr. Jones has managed to make money amid the market's recent tumble, scoring gains of more than 3% so far this month, according to investors. The reason: Mr. Jones has held a large slug of gold-related investments as well as bearish positions on stocks.
• Reuters reports that hedge funds run by sophisticated computer programs are profiting from large falls in stock markets and a rocketing gold price this month, even as funds managed by human beings struggle to cope with high market volatility.
• These "black box" funds are up 4.2 percent so far this month, according to Hedge Fund Research's HFRX index, while the average hedge fund is down 4.0 percent and managers betting on rising and falling stock prices have lost a hefty 7.3 percent on average.
• The FT reports that event-driven is one of the least recognised hedge fund strategies and yet, over the long term, 25 per cent of hedge fund assets are allocated to it. Its diversification benefits from mainstream indices are the principal reason for its prevalence in hedge fund portfolios.
• However, the article also quotes Stephen Harper, chief executive of Saguenay Strathmore Capital (SSC), a fund of hedge funds manager, as cautious, stating: “We like the strategy in principle but we started getting out of it in 2007 and early 2008. We were concerned about lurking beta in the strategy and the low M&A volumes so far this year have not changed our view.” SSC has reduced the event-driven portion of its multi-strategy funds to just 1-2 per cent.
• Reuters reports, hedge funds, wary of more intervention by European stock market regulators, are being forced to rethink investment strategies as authorities decide whether to extend short-selling bans.
• Finally, Bloomberg reports that speculators increased bullish bets on agricultural commodities to the highest level since early May after adverse weather eroded yield prospects for corn and soybean crops in the U.S., the world’s top grower and exporter.
• Hedge funds and other speculators raised their net-long positions across 11 agricultural futures and options by 15 percent to 776,774 contracts in the week through Aug. 23, government data compiled by Bloomberg show. That’s the highest since May 6. Funds became bullish on wheat for the first time since June and wagers that soybeans will gain rose 64 percent.

What does all this tell me? Nothing really new except that most hedge funds are underperforming because they have way too much beta in their portfolio. Just like pension funds, mutual funds, and endowment funds, they too are suffering and licking their wounds as this summer's high-frequency trading (HFT) hurricanes have wreaked havoc on financial markets.

Finally, below, Alain Bokobza of Societe Generale, talks about how hedge funds' bearish bets against the Standard & Poor's 500 Index increased to the highest level since 2008 after this month's stock slump raised concern that economic growth is slowing. Remember what I said above, when hedge funds are all on the same side of the trade, expect a counter-reaction, which could mean violent bear market rallies.

It is my belief that all these institutions have to make up for August's savage losses. And how are they going to do it? By cranking up the risk dial, especially in liquid, large cap technology stocks. Markets will remain volatile, perfect for traders, but I remain long risk assets, short gold, and short volatility.