In 2006, Citadel made an absolute killing by taking over the energy positions of failing hedge fund Amaranth at a very deep discount. Unlike Amaranth, Citadel wasn't in a liquidity crisis, and could afford to take their time selling off the energy positions gradually over time, instead of being forced to sell them all immediately at a deep discount like Amaranth.
Fast forward to August 2007... In the coming weeks, I won't be surprised if news surfaces that Citadel is doing the exact same thing with the mortgage-backed securities of the hedge funds that are failing now. These hedge funds are failing because they hold a lot of mortgage backed securities which are turning out to be much riskier than originally thought. Low credit spreads, defaulting mortgages, low tranches worthless, etc, etc. I won't go into all the gory details, except to say that mortgage backed securities have very little value right now.
Many hedge funds normally sell their mortgage backed security holdings to raise cash for normal operating activities, but because no one wants to buy them right now, the hedge funds collapse and are forced to sell-off all their positions (including equities) at deep discounts (I'm over-simplifying). A good way to determine when a stock sell-off is caused by a hedge fund collapse is via a quick quant factor review. Many huge quantitative hedge funds screen for stocks based on the exact same factors (e.g. earnings momentum, valuation, capital deployment, small market capitalization, etc). What's more interesting about these sell-offs, is that they're not caused by changes in the underlying stock value, so they're almost always followed by stock price increases equally as drastic as the initial price declines.
So if you've actually read this far, you're probably wondering how does this help me profit in this market? Well, if you see a stock undergo a drastic intraday price decrease on essentially no news and the stock screens well on the common hedge fund quant factors (you can screen for these factors for free on Yahoo! Finance), you've probably identified a stock that is part of a quant fund liquidation and a stock that will quickly increase in price over the coming trading hours and days. What makes these opportunities even better is that these stocks are generally very good long term investments as indicated by the very quant factors that the hedge fund purchased them for in the first place.
Thursday we saw Reliance Steel & Aluminum (NYSE:RS) drop over 14% at intraday on essentially no news. This drop is very interesting because it turns out RS screens well on many of the factors that are common to a lot of the big quantitative hedge funds (which is an indication to me that someone was in trouble and was forced to sell off their RS positions). By market close, RS had rebounded more than 50% of it losses, and I won't be surprised to see it rebound further over the next several trading days. Further, I won't be surprised to see more of these drastic drops and rebounds over the coming weeks and months as more quant funds get crushed by the sub-prime-mortgage imposed liquidity crisis.
Want more examples? Check out Dan Knight's portfolio. I know for a fact that Dan's stock selection system uses the same quant factors as many of the huge hedge funds because he describes them in this post (speculative froth or fundamentally driven?). As further evidence, just check out some of the crazy price action in his portfolio on August 8th through August 10th). He even describes the price moves as being caused by forced liquidations in this post (The squeeze is on - hope the end is near).
Over the coming weeks and months, I'll be watching for more sharp price drops and subsequent rebounds caused by liquidating quant funds. As my old college roommate likes to say... Lock and load, baby!