Hedgies hate volatility

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.


5 thoughts on “Hedgies hate volatility”

  1. “I hate multiple analysis and think it lazy. I am a DCF jockey. As such I am probably more acquainted with stock beta in the real world than the average bear, as it were, because beta figures so heavily in my “application” of the Capital Asset Pricing Model. I promise you, were I to use actual beta as defined by CAPM I would get nowhere, my DCF results would be meaningless and I would be groping around in the dark no better than the poor souls in Plato’s Cave, and the majority of my peers. Far from using beta as a measure of a stock’s correlation with the stock market to find its cost of equity, the beta in my models is an entirely subjective measure of the underlying business risk, or in other words, the riskiness of the fundamentals relative to the average listed company (it tends to center around 1.2 for most of my tech stocks, in case you are interested).”

    Will you marry me?

  2. Dear EP,

    I am sympathetic to your skepticism over practical limitations of CAPM, which as you point out, is akin to clipping one’s nails with hack-saw and mitre-box.

    Forgive my ignorance of your business and associated practices, but what is the point of mincing risk-model hairs when one is gearing 24x upon a veneer of OPM? It seems about as futile as reinforcing the roof of one’s Carribbean corrugated iron shack with twine in preparation for a Hurricane.

  3. “Stops are an essential risk management tool … All hedge funds use them.”

    I can’t dispute the second statement, but the first is bunkum.

    Once a position has moved against you, you have a larger risk than before, whether it’s a simple short, a long, or a long vs a benchmark position. Your regularly-scheduled updates to your beliefs about the future may continue to have the same target price, in which case you have a higher potential win, but your risk has grown a bit faster than the win. If the first position was optimal, it’s now a bit too big, and should be pared back if your review didn’t find an even stronger opportunity.

    But paring back a position to its previous risk/reward profile is far different from taking it off the table entirely; for a long equity investor who cares about say, the S&P 500 benchmark, closing it completely would put on a negative bet… why would you do that, just because some new info appeared that probably didn’t contradict your earlier insight?

    The whole idea suggests lousy framing of the trading or investment process problem. How do you make any money if you drive spending most of your time looking in the rear view mirror?

  4. I agree almost wholeheartedly. Stops suck most of the time. They compress your timeframes artificially, increase trading costs, shake you out of stuff, and stops tend to congregate around the same price levels on popular stocks, making them easier to raid or squeeze.

    But every now and then they do save you from the fund-killing positions, the ones you fall in love with in big size and which then move against you.

    These killler positions are more likely to be short positions, however, which if they move against you do indeed increase in size and deadly potential. Longs on the other hand SHRINK in size and risk as they fall, contra your assertion above.

    Thus I would tend to have more aggressive stops on shorts, and give my longs more room.

    And of course, for a long only benchmarked investor, stops should be slightly different. Incurring a stop should bring you back to a benchmark neutral position. As you say, going to zero on a big overweight position would be taking the opposite position, as big a bet as you are removing — when all you wanted to do was reduce your risk.

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