Thursday, August 30, 2007

A Lesson From the Quant Rebound: Don't Blink Too Soon

By Martin de Sa'Pinto, Senior Financial Correspondent
Wednesday, August 29, 2007 2:57:04 PM ET

GENEVA (—Some of the investors who sprinted for the exit when quant funds began to reveal heavy losses after the first week in August may now be wishing they had waited just a little longer. Many funds that saw a wave of redemptions following these losses have now bounced back, and though they may not have fully recovered from the disastrous start to the month, those investors who stuck around are starting to breathe a little easier.

A number of quant funds suffered badly in the first days of the month, and particularly from Aug. 8–10 as a sell-off swept the equities, commodities and low-grade credit markets. The mass selling was initially triggered by the subprime mortgage crisis in the United States, which put huge downward pressure on the prices of other debt securities, related and otherwise. Spreads widened and liquidity dried up. In the face of an increasing number of margin calls, these funds eliminated their most liquid positions in order to raise collateral for their funds, since in many cases it was nigh impossible to lighten their portfolios of the debt securities whose deteriorating market value had caused the problem in the first place.

The widespread damage this market turmoil inflicted on hedge funds using quantitative trading strategies was a result of funds in similar trading positions being whipsawed by what many of them called "unprecedented volatility." Clifford Asness, managing and founding principal of AQR, a $38.5 billion manager, called it a "de-leveraging of historic proportions" in a letter to investors in the firm's quant funds. AQR's Global Stock Selection High Volatility Fund was reported to be down 12.5% earlier this month Previous HedgeWorld Story.

On Aug. 13 Goldman Sachs revealed that its two major quant funds—the multi-strategy Global Alpha fund and Global Equity Opportunities, a long/short equity fund—had accumulated year-to-date losses of 27% and 30%, respectively, of their value Previous HedgeWorld Story. Worse still, more than half of Global Alpha's losses had occurred in the first 10 days of August, while unconfirmed reports said that losses at the long/short fund, known as GS GEO, had brushed 50% year-to-date and then recovered somewhat before Goldman told the market of the difficult start to the month. The investment bank, along with some outside investors, then injected $3 billion into GEO—though Global Alpha did not benefit from any cash injections. In spite of the leverage employed at GEO and the possibility of redemptions, the firm claimed the injection was not a bailout, but rather an attempt to exploit an opportunity.

In a letter to investors dated Aug. 21, James Palotta, vice chairman of Tudor Investment Corp., the investment adviser to the Raptor Fund, noted that an "uncharacteristically sharp" drawdown over two and a half months had left the fund down 8% year-to-date as of Aug. 15. He also noted that in the case of the firm's equity holdings, "in nearly every case, the magnitude of decline appears disconnected completely both from underlying equity value-creation stories (which have limited, if any, dependence on access to credit markets) and from visible, secure, increasing company cash flow profiles." Raptor, which has returned an annualized 19.2% since inception in late 1993, is just one of several consistently outperforming funds to have seen heavy losses in the first half of August.

"Some trend-followers might have problems with these volatile equities markets," Jürg Bühler, a principal at Cayman Islands-based Dighton Capital's UTG Funds SPC, told HedgeWorld in the midst of the market rout. "Most trend-followers have been losing money since the last week in July. Some asset classes have gotten highly correlated, which would not normally be the case. Volatility is rising, risk premiums are going up and fat-tail risks are appearing."

So what should managers and investors do when there are dislocations of this nature? For the investors who injected cash at Goldman GEO, such situations certainly represent an opportunity for quant funds, and indeed for hedge funds in general. "One reason hedge funds make money is because they provide liquidity when the market needs it," Mr. Bühler said. "When people are selling into a market where there is no liquidity, it can create an incredible buying opportunity for hedge funds."

The Aug. 8–10 period, which saw $200 billion liquidated from the market in just three days, is a case in point. "It's a market dislocation—something that's cheap gets cheaper," Mr. Bühler continued. "You need to build a diverse enough business to ensure you can provide liquidity when these things happen."

In fact it is starting to seem that those fund managers who kept faith in their strategies through the early-August turmoil are the ones who have come back most strongly since. On Aug. 9, the Wall Street Journal reported that Renaissance Technologies' $26 billion Renaissance Institutional Equities Fund was down 7.4% for the year through Aug. 8, after losing 8.7% in the first eight days—six trading days—of August alone.

While explaining, in short, that crowded trades were the main factor behind the losses, Renaissance officials said in a letter to investors that "we remain confident that over time the Basic System will match the return of the S&P and, enhanced by our predictive signals, should exceed it." That is to say, the fund would maintain faith in its system which had, after all, performed pretty well until that time. And the tactic seems to have worked: A source close to the situation confirmed Tuesday [Aug. 28] that RIEF performance as of last Friday was up and that the fund would likely close the month either flat or up Previous HedgeWorld Story.

JP Morgan's Highbridge quant funds also suffered early in the month. Highbridge Statistical Market Neutral, a mutual fund that is open to retail investors and does not employ leverage, was down about 7.2% month-to-date by Aug. 9, but had recovered to a loss of around 2.66% for the month—negative 0.88% year-to-date—by the close on Aug. 27. However, a large amount of retail money was withdrawn from this fund in the intervening period, with redemptions totaling around $350 million for the month. The fund now has assets of around $1.45 billion from about $1.78 billion at the start of trading on Aug. 10. Most of the drawdown occurred around Aug. 10, and so the fleeing investors did not benefit from the bounce.

Highbridge Statistical Opportunities, a similar fund that uses leverage and is not open to retail investors, was also hard hit in early August. Several reports put losses at 18%. Although Highbridge does not comment on the performance of its funds, a person close to the firm said this fund too had experienced a "nice bounce" and was "continuing to see an upward trend."

Investors at AQR's Global Stock Selection High Volatility Fund were, by and large, not spooked by the market turmoil earlier this month. Indeed, it seems that AQR's largest hedge fund has actually had net inflows month-to-date. It also has recovered from its negative 12.5% performance as of Aug. 10 to negative 3.5% as of Aug. 27, leaving it up almost 3% year-to-date, said a person familiar with the fund. It's actually turning into a pretty good month for AQR: The firm's non-quant hedge funds are enjoying a solid month, with the Global Asset Allocation fund up more than 2.5% and the Global risk premium fund up 2.78%, this person said.

The flagship of the world's largest hedge fund operator, Man Group's AHL Diversified, which looks to exploit price trends in futures and foreign exchange markets, reduced positions in order to preserve capital during the broad market retreat. Man is ready to redeploy that capital when solid trends are re-established. The AHL Diversified fund slid 6.9% in the last week of July alone, when trends first began to break down, leading to an overall loss of 3.9% for the month. Even so, the fund slipped further during the August turmoil, losing another 6.9% by Aug. 10. This fund, too, has staged something of a fight back; month-to-date performance stood at negative 2.83% on Aug. 27. As of that time the fund was in positive territory year-to-date, with returns of around 4.75%.

"We're trading on over 100 markets, including indices, cash and commodities," said one portfolio manager at Vienna, Austria-based Superfund, on Aug. 10. His firm advises trend-following strategies that manage a total of $1.6 billion. "The subprime effect has nothing to do with soybeans, but it has affected the markets anyway. For trend-followers, the market drop like the one we saw was the worst thing that could happen, because trends have been broken."

But in the midst of the market storm, this manager said that his firm would be not be changing tack, in spite of losses exceeding 7% in July and a difficult start to August. "In this sort of highly unusual situation, you can either change your system to short-term or day trading or try to manage downside volatility. We're focusing on volatility," he said.

This person added that his firm was confident in its system, and would therefore not be looking to "fix" it because of highly unusual developments in the market. "If you stick to your system, you will make money," he said. "As soon as you start to change your system, you'll lose money." There has been no performance update from Superfund since that time. However, the experience of Goldman, Highbridge and others in the latter part of August suggest that the Superfund manager may have a good point.

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Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.