Quant Quandary

Hedge funds pulled in $45 billion in new money during the third quarter of 2007, bringing the nine month total to $164 billion vs. $126 billion for the whole of 2006. That's impressive and goes a long way in explaining why markets - particularly emerging markets - are performing the way they are. People are still throwing tons of high-powered money at them. I say "high-powered" because hedge funds can and do leverage, sometimes as much as 50-to-1, depending on their strategy. So one dollar raised may end up as twenty dollars in Brazilian shares. Furthermore, we now have funds of hedge funds becoming very popular, further hiking total leverage (ding, ding, ding - does anyone hear the alarm bell ringing? Read your financial market history, folks. Hint: trusts of trusts in 1929).

Total assets for hedge funds reached $1.81 trillion. And therein lurks a serious quandary for quant hedge funds, who depend on being nimble and highly specialized. For example, if a manager identifies a discrepancy or mis-pricing in a market he may put on a spread trade to capture the difference with seemingly little risk. However, as more and more managers identify such opportunities the pickings become slimmer - the law of lower marginal returns sets in. Typically a manager then has two choices: find another opportunity, or hike leverage on his existing trade to make up for the smaller profit margin.

With so many hedge funds now scrutinizing the entire world for relative value trades, new opportunities are not easy to find. So, I bet what is happening is this:

a) Leverage is being increased on existing trade strategies and,
b) Funds are increasingly taking outright positions, i.e. becoming net long or short, exposing themselves to the full force of the market, instead of putting on spread trades.

Why do I say this? Let's see...

• The equity arbi funds that take spread positions based on LBO/takeover transactions can't be doing well. The pipeline has run dry and existing deals are either getting re-priced or cancelled altogether. There are big losses simmering there...
  
• The SIVs and other conduits borrowing short-lending long are dead. All other hedge funds that followed the same strategy are in trouble, too.
• The CDS-equity correlation party is over, too. Broad equity indices are near all-time highs, but corporate CDSs are nowhere near as cheap as before. Risk is now being "re-priced", to say the least.
  
• One of the only games left is one of the oldest: momentum trades. In other words, identify a market(s) that is trending strongly and join the party. And guess what? This is exactly what is happening: you can see it in the way that bullish markets extend and extend, be it Chinese stocks or crude oil.

Bottom line? It seems to me that quants are not being as conservatively "quantish" as before... Loaded with new money to "invest" (as Alan Greenspan famously said about wild-eyed speculation before the dotcom crash, "is that what we call it now?") and fewer arbi/spread opportunities, the money must increasingly be going to outright speculative positions.

Add increased leverage and what we have going on here is bubble pumping in spades.

Oh, and I forgot to mention... Anyone still thinking that hedge funds are the playground of the rich and famous is woefully behind the times. ANYONE can buy into a hedge fund these days - some with as little as $10.000: i.e. 100% retail investor stuff. This occurs through the aforementioned funds of funds and - no surprise - the biggest piece of the $45 billion raised in the 3Q2007 went to...funds of hedge funds. A cool $22.5 billion. Contrast that with the puny $990 MILLION raised by plain old mutual funds during July and August and you have yourself a trend, eh?

Did someone say the retail investor is absent from this bubble? Don't think so....