Investing in a Crisis Market
Todd Petzel of Offit Capital Advisors kicked off the Hedge World’s Managed Futures and Commodity Trading Conference last week at Chicago’s University Club. Buy side professionals gathered to discuss their investment options in the current crisis market. They listened as Petzel went through examples of failed investment approaches and the common factors each case shared.
He began his discussion of ‘what not to do’ in July 2007, when hedge fund Sowood Capital Management was executing trades through SWAPs. They went long on a basket of bonds and hedged their bets by going short on equities. The problem was that the bonds sold off quickly while the equity hedges stayed on their books. The firm was left without enough capital to defend their position or the ability to re-negotiate the SWAPs. The firm had to close up shop.
Then in August, Petzel described a second hedge fund that crashed and burned. This one had relied on quantitative strategies to liquidate “easy” positions. In this instance, their unique algorithms had similar features as other computer generated models. With volatile markets, the algorithms were simultaneously getting negative signs and pulling out of losing positions. This contributed to a downward spiral and the hedge fund experienced losses above 20 per cent.
Petzel also commented on the Federal Reserve’s aggressive moves in August 2007.
“An entire generation of managers had grown up believing that it was opportunistic to buy on the dips,” he said. “The Fed’s actions gave people confidence that August was just a dip.”
Petzel explained that deeply discounted loans were picked up by hedge funds, often with some leverage. With rates of return in the high teens or low twenties, these managers were seeing additional sales and mark to market losses of more than 15-20 per cent by the time January 2008 came around.
“Some of the most liquid markets in the world could not attract risk capital to ‘correct’ the extremes,” Petzel said.
He explained that there were a few common threads between the cases he had presented. First, when managers saw market movements, their first reaction was to take advantage of the opportunity to increase their book of business. Second, the hedge funds relied on heavy leverage when they were executing their trades.
Another shared trait was that most of the positions involved Over the Counter (OTC) derivatives. OTC trades do not guarantee a transaction but there are exchanges that provide OTC clearing functions. The problem is that these types of trades can be bundled in sizes that exchanges normally wouldn’t allow. When the market has liquidity issues and there are no designated liquidity providers for OTC trades, you could be stuck with a bad position and unable to sell quickly.
Before the credit crunch, the hedge fund Amaranth Advisors was in the papers for collapsing after acquiring large positions of natural gas through OTC trades. The trade sizes were well beyond the limit of what an exchange would allow. The risky positions ended up costing the hedge fund over $6 billion and forcing it to close.
“Question whether the customization of OTC derivatives and their apparent cost savings are worth the negatives when liquidity falls,” Petzel said.
With so much uncertainty in the marketplace, it is important to learn from past mistakes. Even though certain sectors of the market are attractive in times of crisis, hedge fund managers must carefully weigh their options before investing. As Todd Petzel pointed out, the ones that went before you learned the hard way.
