Report says hedge funds, portable alpha and 130/30 all leading to (financial) climate change

5 May 2008

Last year, we published a couple of articles on the somewhat Malthusian possibility of a global shortage of stocks available for borrowing. (”A Shortage of Shorts?”, “The Arms Merchants of 130/30“, “Is There a Capacity Constraint Facing 130/30 Strategies?”).   

Although the 130/30 market has grown since then, it remains in the very low hundreds of billions globally.  Yet in a report released a few days ago, the Security Traders Association (STA) blames recent market volatility, in part, on 130/30 funds.  Says the report:

“There has also been a significant increase in the number and impact of 130/30 funds, used by both traditional mutual fund and hedge fund managers.  That said, all of these funds have at least two common denominators: they seek to raise new capital, and they seek robust returns. In fact their enhanced returns allow them to raise more capital. In order to earn the returns needed, they may deploy investment and trading strategies aimed at short-term performance. This trading behavior (with a focus on a short-term window of opportunity) in itself creates movement and momentum among stocks that fuels volatility and velocity.”

High velocity hedge funds seem to be primary focus of the STAs concern.  But 130/30 isn’t the only institutional investment strategy at which the STA points a finger.  The use of derivatives (for example, for portable alpha) is also identified as a growing source of market volatility by the report:

“Investment banks, hedge funds and traditional institutional managers are increasingly using derivatives and options strategies. Traditionally, options have been used to hedge against volatility. While this is still the case today, derivatives are also employed because they provide greater leverage to the investor/manager, lowering the manager’s cost of capital and enhancing returns. When positions are established in derivatives, the counterparties to those derivatives trades hedge in the cash or underlying market. Options volume is up, driving up hedging activity, which may in turn increase volume and volatility in the cash market.”

While an outright shortage of stock borrow may still be a long way off, this report suggests that increasing volatility is a much more immediate result of the dramatic growth in strategies that use short-selling.  As species, hedge, 130/30, and portable alpha funds may not face Malthusian overpopulation for a long time.  So their impact on the entire global financial market might therefore be a better example of the Gaia hypothesis.

(Note: Pensions & Investments ran a great summary of the entire STA report today here.)    

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