CALLAN INSTITUTE Hedge Fund Monitor Second Quarter 2017 Bear Ahead? Beware of the ‘False Charge.’ FIDUCIARY PERSPECTIVES “Be Prepared” I wondered aloud whether the pot-clanging technique still —Boy Scout motto worked. It did not, he quickly countered; bears today were quite used to that behavior. Now you need to holler and throw rocks When I was a Boy Scout backpacking in the Sierras, I thought at them, he declared.1 I had timeless advice for dealing with black bears rummaging through campsites looking for an easy meal. The bears were Seeing me gob-smacked by his provocative advice, he crisply nimble climbers, and many had already figured out they could added an important disclosure, “But beware of the false snatch food that had been stored high in trees by ropes. charge.” Satisfied that he had dispensed sound advice with all the necessary disclosures, he left us to ponder the worst-case To manage this well-known risk of motivated bears, my troop scenarios implied in his warning. It seems today’s more condi- assigned shifts of scouts at night, rotating every hour, to watch tioned bear has learned how to check the resolve of its “coun- for marauding bears on the perimeter. To scare them off, the terparties.” More on this later. sentry clanged a pot or made some raucous noise. That simple but chaotic-sounding response seemed to work fine—the four- As we look at capital markets today, we must worry about footed opportunist, however hungry, usually got the hint and another kind of evolving bear that tests the courage of our con- strolled off in search of less noisy campsites with a hint of food victions. I am not referring to the traditional bear associated in the air. with steadily declining stock prices driven by a looming reces- sion or other deteriorating fundamentals, but rather one that Fast forward three decades. I recently returned to the Sierras, suddenly explodes on the scene with, er, barely the slightest sharing a similar backpacking experience with my son. We provocation. After a quick purge of market confidence, prices came upon what appeared to be an experienced backpacker. recover speedily and fears subside. Given how fast information Unshaven with layers of trail dust, he seemed qualified to dis- travels, these flash crashes are predictably unnerving, particu- pense advice about risks in the wilderness, including bears. larly for the casual observer or inexperienced investor. 1 For more tips on bear safety, see www.fs.fed.us/visit/know-before-you-go/bears. Knowledge. Experience. Integrity. 1 FIDUCIARY PERSPECTIVES (Continued) This Fiduciary Perspectives reviews recent historical examples of these sudden market dislocations that proved to be “false LTCM Crisis – September 1998 charges.” A cursory look at each event’s contributing factors A giant hedge fund’s normally unrelated trades became can help to illustrate what defines a temporary crash versus a related. LTCM’s collapse spooked markets but also bolstered more self-sustaining, systemic move like those that followed the credibility behind the ‘Greenspan Put,’ the view among the Dot-Com Bubble in the late ‘90s and the Global Financial traders that the Federal Reserve and other central bankers Crisis in the mid-2000s. Given this distinction, risk-seeking would act to stem market downturns. behaviors leave some investors more exposed than others to a sudden bear market rout and rebound. Aware of these behav- iors, investors can be better prepared to protect their own capi- One often-cited “correction” that did not translate into a full tal and position themselves for a safer investment experience. bear market surrounded the plight of Long-Term Capital Management (LTCM) in 1998. Prior to its demise, this $4 bil- “Forewarned, forearmed.” lion hedge fund boasted a well-diversified portfolio loaded —Ancient Roman Proverb with a wide array of profitable but normally unrelated trades (e.g., yield curve arbitrage, emerging market debt, credit arbi- Respect Wildlife trage). Comforted by its diversification, LTCM applied a signifi- Although capital markets are much more efficient than in years cant degree of leverage (more than 25x its equity capital) to past, they are also potentially less stable in the short run. generate attractive risk-adjusted returns. However, as events Sudden crashes are the manifestation of this instability, and around the world took their toll on investor confidence (e.g., a they can affect broad markets, niche markets, or risk factors series of emerging market currency devaluations in Thailand within a market. Then, almost as soon as these markets crash, and Russia), the S&P 500 fell 15.4% in July and August 1998. prices find their footing and jump back to their former levels, In this nervous setting, the previously accretive leverage com- leaving witnesses to wonder what just happened. bined with unexpected illiquidity to create a toxic mix for LTCM in September. Under the supervision of a Federal Reserve Ill-fated investors can suffer permanent damage for one of two worried that the fund’s collapse would lead to broader losses reasons. First, investors lose their resolve and sell risk assets throughout the financial markets, LTCM’s creditors assumed to be in safe harbors until the risk becomes better understood, control of the portfolio. but the market rebounds too quickly for them to get reinvested. Second, counterparties to investors, such as financing agents The process illustrated how LTCM’s trading partners could or underlying equity investors, yank their capital when margin step away from their bids as they witnessed the equity capital calls are unanswered. Since catalysts of such flash crashes of an overly confident risk taker being consumed by widening may be tied to deep-seated fears, the sudden ferocity can spreads. However, once the losses affecting LTCM—as well prompt any nervous participant to run for cash, Treasury as Russia and other related trades—were realized and dissi- bonds, or other havens. pated, the market regained its footing and marched to higher highs by the end of 1998. That correction of 1998 proved to be History has a variety of market meltdowns that occurred sud- only a brief setback for other long-term investors of risk capital. denly, leading to massive losses for the least prepared, or most Based on that experience of “temporary” systemic risk being over-confident, investors. Then markets quickly recovered reversed, in part by the Fed as a buyer of last resort, the nar- without seemingly any lasting damage to those able to stay rative behind the “Greenspan Put” gained wider acceptance. invested or move more nimbly. Consider these three examples: That is, market speculators were emboldened to buy future 2 FIDUCIARY PERSPECTIVES (Continued) market dips during brief spasms when systemic risk bared its or even positive, depending on whether they were able to add to teeth, confident that central bankers would step in at moments their positions that had become even more attractively priced. of peril. Flash Crash – May 6, 2010 Quant Crash – August 2007 A meltdown in the Dow Jones Industrial Average over a matter Some quantitative strategies imploded under pressure from of minutes showed how fragile markets are, even with steps external events. Highly leveraged firms were exposed to by regulators to control market behavior. painful losses; those more defensively positioned were able to ride out the storm and emerge in good shape. During the recovery from the Global Financial Crisis (GFC), some key developments affecting the market’s underlying Another notable “false charge” scared investors in early August liquidity became increasingly apparent. To address the unsafe 2007 with the Quant Crash, when a confluence of events led to levels of leverage in the U.S. banking system that helped to losses of 30% or more, primarily in quantitatively driven strat- precipitate the GFC, the Dodd-Frank legislation effectively egies with highly levered equity capital. These strategies bet barred financial institutions backed by federal deposit guar- on the mean-reverting relationships between overvalued and antees from providing market liquidity. Consequently, when undervalued securities. Since such strategies are not neces- markets fall to attractive levels, these potential buyers with big sarily betting on the direction of equity markets, broader market balance sheets are less able to buy when others are frantically participants were only marginally affected. Because managers selling regardless of price. of quantitative strategies often have similar, if not identical, trades with varying degrees of leverage, their equity at stake is Meanwhile, as a result of SEC regulations to promote efficient subject to counterparty risk. markets, high-frequency trading firms assumed a growing presence in the most liquid markets. These firms, with their However liquid the underlying factor exposures were, the lever- highly automated order-generation processes, aggressively age needed to make those strategies profitable enough to pursue tested the market’s bids and offers to identify pending trades with scale was a key issue. When significant losses occurred, from larger market-moving investors like mutual funds. Being even if not realized, the counterparties could take full control of able to discern when to trade in front of those orders became those positions to protect themselves while demanding more a profitable business. equity capital from the affected manager. The highly leveraged quant managers unable to provide that capital realized losses On May 6, 2010, the combined effect of the sidelining of when the prime brokers liquidated their positions. Others with massive balance sheets and rise of high-frequency traders less leverage, or more equity capital to contribute, were able to contributed to a self-sustaining market sell-off. With the retain positions, even while the liquidation process caused the Greek debt crisis agitating investors, the Dow Jones Industrial relative value spreads to widen to more painful levels.