Hedgies hate volatility

April 9, 2008 · 3 Comments

Clever Felix over at Market Movers has an issue with hedge fund returns and volatility. He links to a Bloomberg article which points out that not only the pre-eminent Quant still extant, James Simons, but also ex Tiger sidekick and champion fundy Steven Mandel, have had severe drawdowns lately.

“Much of the problem this year has come from extreme price movements in different markets,” writes the author of the article, Katherine Burton, trying to explain. Felix’s plaintive reaction speaks volumes about one of the great misconceptions about managing long short money:

I have to say I don’t get it. Aren’t hedge funds precisely the asset class which is meant to benefit from volatility

Baruch is here to help, and the answer is no, no and double no. Hedge funds hate volatility. Note I mean real, up and down volatility, not the purely downward kind. You all know what stops are: when a stock or position moves against you, through a pre-assigned loss level, it gets taken off, sold if long, bought back if short, liquidated, whatever. Stops are an essential risk management tool, an insurance policy to protect your fund from significant drawdown if a position goes against you. All hedge funds use them.

There is a mysterious process by which stocks tend to get drawn towards widely held stop levels in highly volatile markets, in which the blasted thing moves against you, until you are out, with, say a 7% loss on a position you thought would make you 20%. And then it moves rapidly in the way you wanted it to in the first place. You re-enter the position, determined not to let one mistake beget another, at which point — you guessed it, you get rapidly stopped out again for another 7% loss. If you simply stayed in the position you would be flat, but instead are down 14%. Your stop policy has become a false friend. If anyone is watching, you appear deeply stupid.

Hedge funds as I know them are like every other fund: they like long, visible trends, clear cues to go long or short stocks. The problem is that hedge funds are sold as Felix says, and the fallacy is widespread – for example, the strategists at my beloved employer told the punters, correctly, that this year would see a lot of volatility in equities. So, they said, increase allocation to equity long short, which struck me as precisely the wrong thing to do. Paradoxically in times like this it is the dumb, directional money, the long only crowd, who can ride out volatility better. But of course with them you can only “lose less money” in long-lasting bear markets.

Incidentally this March – Baruch is reliably informed – has been one of the worst months ever for hedge fund returns in any class, but particularly long short equity. 75% of them are supposed to have lost money. No prizes for noting that March has been one of the most volatile months in ages, encompassing the rally post the Bear rescue and 75bp rate hike, and the awful swoon beforehand.

No, proper schmalpha is very hard to come by in volatile times.