Who said hedge funds don’t like chaos?

Feb 18th, 2010 | Filed under: Performance, Analytics & Metrics, Today's Post | By:
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Critics of hedge funds often charge that they simply sell insurance (“volatility”) for a premium and cross their fingers that they never have to pay up.  Hedge funds, they say, are “short vol.”  When volatility goes up, they go down, and vice versa.

But there may be a little more to the story than meets the eye. More…

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  1. [...] AllAboutAlpha: Who said hedge funds don’t like chaos? [...]

  2. I wanted to comment on your final point. I agree that an environment of high volatility and high average stock correlation is challenging for active managers but also feel there is a cause and effect that should be noted. As we know, the hedge fund industry was substantially larger in 2008 than 2000, both in absolute terms and as a percentage of market activity (without any hard data I would also strongly suggest that leverage was substantially higher too since financing terms were ridiculously easy in 2007-08). Goldman’s “VIP List”, which tracks the 50 stocks that “matter most to hedge funds”, underperformed the S&P 500 by 11% in Q3 2008 (the report is dated 10/1/08 if you have access to it). That is stunning underperformance for an industry that prides itself on stock picking skill, especially in a period when markets are getting pummeled. What seems to have happened is certain names became extremely crowded and as liquidity was withdrawn by prime brokers after the collapse of Lehman hedge funds simultaneously blew out of positions resulting in 1) massive underperformance of crowded names, and 2) a large rise in correlation amongst these names. Equity based hedge funds that performed well during this period appear to have been in less-crowded names and had a strong short book or general hedges. The bottom line is that while high inter-stock correlation coupled with high market volatility is certainly far from ideal for active managers it appears that, in 2008 at least, high correlation can be caused by those same active managers. Consequently, for anyone investing in hedge funds it is probably wise to research how many their managers’ positions overlap with their industry peers.

  3. [...] Do hedge funds thrive in periods of market chaos?  (All About Alpha) [...]

  4. In aggregate, hedge funds are long risky assets and so are short volatility. Managed futures and CTAs have shown themselves to essentially be long volatility however.

  5. [...] Do hedge funds thrive in periods of market chaos?  (All About Alpha) [...]

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