Hedge Funds Had Necks Out as Waves of Selling Crushed Stocks

(Bloomberg) -- As waves of selling lashed stocks again and again this week, it wasn’t just newly christened day traders at discount brokerages getting schooled in market physics.
 
Some of the most steadfast believers in a rebound have been the biggest money clients of Wall Street banks -- hedge funds and quant shops -- and that may be one reason why the chaos refuses to clear. It may seem a bit counter-intuitive that one key group’s refusal to capitulate is exacerbating the chop, but the theory is that their reluctance has the rest of the market bracing nervously for another wave of selling.

“It really didn’t drive a lot of panic,” Benjamin Dunn, president of the portfolio consulting practice at Alpha Theory, which works with money-management firms, said of the rout. “It’s also people conditioned to buy the dip.”

Three U.S. prime brokerages said that rather than bail as Monday’s selloff deepened, clients made only minor adjustments in an effort to stay fully invested. Funds that held long and short stock positions absorbed the shock and largely stayed bullish Tuesday, according to JPMorgan Chase & Co. and Credit Suisse Group AG. Equity quants, for their part, did what they’re supposed to do: look for and buy mispriced equity securities. Meanwhile, data from Credit Suisse show hedge funds were still in the green for the year -- as of Wednesday, that is.

The exposure is part of a wider trend in which money managers, blindsided by the suddenness of this week’s reversal, delayed precautions that might have subdued its velocity. A series of head-fakes as the week progressed and a belief that the economic backdrop didn’t warrant the plunge left traders confused, said Chris Harvey, head of equity trading at Wells Fargo Securities.

Starting Monday, “We did see people take off protection in the derivatives space, only to come back later that day to put on in some cases two and three times what they took off,” Harvey said in an interview. “It was just a mad dash for protection, mad dash for re-positioning -- a lot of that was occurring where there just wasn’t a lot of liquidity so prices quickly gapped.”

While hedge funds pared net exposure, they added single-stock longs Tuesday, Morgan Stanley said in a note. Prime brokers at JPMorgan, for their part, say market-neutral hedge funds saw “no significant change” in net exposure, while gross leverage staged a partial recovery on Monday after a decline on Feb. 2, according to a client note. Equity long-short funds, meanwhile, covered bearish positions by snapping up stocks across consumer discretionary, health care, industrials and tech, while paring exposure to financials and utilities.

Managers may have been willing to ride the storm out partly because of the buffer provided by a stellar performance in January. And, despite the worst day for U.S. equities since 2011, most hedge funds were still profitable for 2018 prior to Wednesday, according to data compiled by Credit Suisse prime services.

In the end, no effort to cushion the blow could’ve done much to halt the selloff, in which more than 9 billion shares have traded for five straight days in U.S. markets. Not every bank told the same tale. Bank of America Merrill Lynch reported record selling from its hedge-fund clients.

On Credit Suisse’s platform, equity quants who take bets on specific contours of the market still had gross exposure to equities like never before heading into the Thursday plunge. Rather than acting as net sellers, the cohort used rising volatility to take advantage of market mispricings, according to the Swiss bank, which saw a pickup in trading activity.

Market-neutral funds -- because they hedge out swings in the broader indexes -- enjoyed the benefit of a broad selloff that wasn’t especially damaging to any particular industry or factor. Those funds slipped just 0.3 percent in the four days through Wednesday, according to Hedge Fund Research, compared with a 5 percent decline in the MSCI World Index.

Similarly, equity long-short managers saw no meaningful change, even though market declines did cause a slight dip in gross exposure, Credit Suisse data show. Still, by all appearances, professional investors had remained calm on the heels of Monday’s maelstrom, said Mark Connors, the head of risk advisory at Credit Suisse.

“It was a really focused and narrowly affected market segment that had an adverse impact because they’re using index options to adjust volatility,” Connors said in a telephone interview. Clients hadn’t seen too much damage to their portfolios and were “not necessarily nervous,” he said.

--With assistance from Sarah Ponczek

To contact the reporters on this story: Dani Burger in London at dburger7@bloomberg.net, Sid Verma in London at sverma100@bloomberg.net.

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Eric J. Weiner, Cecile Vannucci

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