The Great Hedge Fund Unwind Is Under Way

News that Citadel Capital has had its worst year ever should be final confirmation, if needed, that the great hedge fund unwind is underway. If Citadel can't navigate the current year, then a good bet is that most current funds can't. After all, only two strategies were up in September -- short bias and macro -- and most strategies are down more than 30% for the year-to-date. The capital-weighted  performance is worse if you consider that some of the better performing strategies, like short bias, manage negligible capital.

So, should we be worried? Happy? Other? Well, you need to understand the unwind  to understand the nonstop selling of equities going on worldwide. It's partly about revaluation in the face of long and deep recession, but the selling is also about broken hedge funds being forced to sell whatever is liquid to respond to margin calls, and equities are more liquid than anything else they own, so they get sold.

It should sound familiar. It's like what happened last summer during the quant-quake. Oodles of quant funds got smoked as heavy selling of their holdings presaged multiple hedge fund meltdowns, in particular two at Bear Stearns. Something similar is going on here under the surface, and it's much wider than Citadel. Some have called it a margin call to the system, and that metaphor feels right to me -- right down to the likelihood that it ends with the failure of a couple of hedge funds.

While I'd like to think it can happen cleanly, my belief is it can't. It's partly because too many levered funds are trying to go to cash at once, and it's partly because too many funds, trapped in illiquid positions, are selling the same stocks. And, at its worst, we have funds trying to martingale their way out, doubling down wherever they can, hoping against hope that a sharp move will cut their losses before clients yank out all the capital anyway. These latter funds are ticking time bombs, like a skein of LTCM-lites, all roiling markets in their death throes.

Welcome to the great hedge fund unwind.

Comments

[Smarty_Pants:]

Leverage works both ways, but we knew that.

Look at a long term chart of the Dow:

finance.yahoo.com/q/bc...=

Draw a straight line fit starting at the beginning through 1980. Pretty close match with small deviations from the line. It's only after the start of the last great bull market in 1982 that prices make immense deviations above that long term path.

Also note that the 1980s were where the US Government abandoned any pretense of fiscal restraint and spent ever increasing amounts of money funded by borrowing it.

It is too far-fetched to conclude that the last 25 years of market performance were mostly a credit induced bubble that is now deflating?

2008 Oct 16 12:02 PM

[Malkiel:]

Riddle me this, batman: if the hedgies are unwinding, which opposing parties must be spooling up their purchases of bargain stock? Is it the specialist firms as market makers who are taking it all back in, ready to become obscenely rich in the next bull, or are there big mutual fund players out there guaranteeing their place among the firmament of fat funds of the future by warehousing shares at wholesale? If us small players want to get a piece of whoever is the dealer at this blackjack table, who do we buy into?

2008 Oct 16 12:06 PM

[Statius:]

You need a semi-log chart to draw a credible trendline through a long-term chart

2008 Oct 16 12:11 PM

[ASCii:]

Why is this beginning to happen now and not when the credit crises was at its peak, before the bail-out bill was passed?

2008 Oct 16 12:18 PM

[helplessobs...:]

It important for investors to know we are in a secular bear market that began about 8 years ago in 2000. The recent climb in the DJI to 14000 was merely a cyclical bull run within this secular bear. Secular markets, both bull and bear last a long time, typically 15 to 20 years so we have a long time to wait for the next secular bull. In the secular bear from 1966 to 1982 the DJI was range bound between roughly 500 and 1000. It hit 1000 five time before it finally broke thru and the new bull run was underway.

2008 Oct 16 12:18 PM

[Statius:]

Yes, It is far-fetched to conclude that the last 25 years of stock market performance resulted mostly from a credit induced bubble that is now deflating.

The credit induced bubble of the last 8 - 10 yrs is centered in real estate prices not stock prices. Not to say the stock market won't go down 20% from here because it might.

US Federal debt as a % of GDP peaked in the early 90s.

2008 Oct 16 12:18 PM

[whidbey:]

Bring it on! We need to clear the air even if it singes our lungs. At some point it must be complete so that energy can turn to other things.

But Now: After the hedges, comes the commercial real estate then the credit cards and car loans. When each will crumble is not known.

In part this is not intrinsic bad management, but the effects of a close linked financial system; one too close linked. Anything can happen in such an interdependent system. We must expect Russia and Brazil to experience serious financial problems that may have political implications. It has only started.

2008 Oct 16 01:05 PM

[JasonC:]

HelplessObserver is correct about the scale of long markets, and where we are in this one. But those are also the best times to buy of all time. The current situation is closest to the 1974 lows.

The article is right that we are seeing forced selling of everything the End of the World Traders pumped to infinity immediately prior. It is creating great bargains already. A less noticed aspect this week is that the rescue of the financials by governments has caught those end of the world traders long huge CDS bets and short the financials themselves. They have to sell everything else they own to meet margins when those bets move against them.

Look at the materialis sector to see what I mean.

Right now you can buy producers of steel, plastic, aluminum, copper, titanium - for an average PE of 4.5 and 40% of sales. Yes their earnings will drop in a recession. Last I checked, twice 4.5 is 9.

The financials are an even more extreme case. The internals of all the announcements show they are adding huge amounts to reserves and marking down security holdings, and that is their losses. Their ongoing earnings already exceed their elevated loan losses. Their earning power when this storm abates will make these prices work out to PEs around 2.

There are also retailers of the first quality being taken out and shot, at this point. Techs that have performed splendidly in an operating sense, meanwhile, get no respect (see IBM as an example), even when they saw the price-cut shakeout coming and have already moved costs to flat-world rock bottom levels.

Distressed selling regardless of price, fear, shellshock, awestruck staring at the headline figures, swearing off stocks like the bottle --- but precious little focus on actual details of companies and what they will earn in the future.

Trend followers are lemmings, and they *always* lose. Always.

2008 Oct 16 01:16 PM

[peterthepai...:]

70% down from the top...thats a buyin opp.

gravity a bitch innit!

2008 Oct 16 01:55 PM

[notsosmart:]

nobody ever answers.what good are hedge funds except to make the rich richer?they skew the markets & may have ended good long term investing.

2008 Oct 17 09:33 AM