[Thank you to Matt Grayson for the chart below.]

Several times over the past few years, we’ve seen many hedge funds apparently deleverage near a market bottom, only to pile back (late) after the market starts to recover.  The chart below shows what happened last fall, when a hedge fund tracker – which, by definition, won’t deleverage suddenly – bounced back far more than a sample of hedge funds as equities rebounded in October.  (Despite the data issues, we use the HFRX Global Hedge Fund Index here because we can get daily data).

A question that we’ve wrestled with is what’s driving this apparent deleveraging at what, in retrospect, appears to be the wrong time.  After all, hedge fund managers as a group have proved exceptionally adept at managing risk through volatile market conditions.  And for the subset of managers who focus on value stocks, one would think these market dislocations would be an opportunity to add, not cut, positions.

I’ve concluded that there are three interconnected forces that make it difficult for managers to hold losing positions:

  •  First, a byproduct of institutionalization is that investors now have exposure expectations, in addition to strategy/sector/geography classifications.  It’s been taboo for some time for an equity long/short manager to migrate into distressed, even if the opportunity set is more compelling.  But institutional investors and their advisors now seem to place great emphasis on risk stability; hence, it’s harder for a manager to sit on cash as the storm clouds form, but before the storm hits.  Consequently, they’re more likely to find themselves playing defense in the midst of a market drawdown, rather than capitalizing on it.
  •  Second, post-crisis investors used their leverage to force managers to ease liquidity terms – and managers were inclined to do this in lieu of materially cutting fees.  Combined with the institutionalization of the business, this has led to shorter and shorter evaluation periods.   Ask any manager who was flat in 1Q2012, and you’ll likely hear stories about being berated all April by investors for having missed the rally.
  • Third, macroeconomic factors have simply made it more difficult to remain confident in longer term views given the indeterminate downside of a breakup of the euro zone, further sovereign downgrades, the US fiscal cliff, etc.

In the face of this, we find managers struggling to remain focused on core value or to have the fortitude to add to the position.  However, these price dislocations can provide compelling buying opportunities — sometimes at irrational prices.  How many of us would welcome the opportunity to buy a good value stock 25% below where a smart, trusted investor built a significant position?

However, it will be important going forward for smart hedge funds to be selective in how they build their investor bases.  As one manager put it, the “vocal minority can ruin it for everyone.”

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