December 5, 2007

Hedge Funds and Low-Frequency Volatility

The Economist writes in an article titled "Crunch Time":
Perhaps this will be the pattern for markets for some time: a breathtaking switchback ride as risk-seeking investors try to take advantage of short-term trends (and by their actions, make those trends more vicious). But that does raise the question of why volatility was so low in the period 2004-2006. After all, plenty of hedge funds were in existence during that period.
Volatility was not low in 2004-2006. It was extreme. Prices were rising everywhere, especially in the housing sector. This is a form of volatility, also known as a crack up boom. Prices going up fast, later coming down just as fast or even quicker. What is that if not volatility?

This kind of volatility just happens to have a bit lower frequency. But it's the amplitude that really matters.

Hedge funds where going fast in 2004-2006. They were just all running in the same direction. Now they are acting like headless chickens until the herd finds a direction again, but they have to keep running even faster in order to make up their existing losses.

The usual hedge fund payment structures are a very strong incentive to using Martingale strategies, due to the "high water marks" in their payment structures. The managers' fees are stopped until all losses are recovered, even from unreasonably high speculative peaks.

This is of course completely reasonable. The managers have already been paid for the peak. Paying for it again would actually encourage volatility. Many hedge fund managers have instead decided to just call it quits instead of trying in vain to reach former highs, leaving the managers paid at the top and the investors paid at the bottom.

The economy reflects exactly the kind of behavior that these payment structures encourage. A long hard push to the top. What comes after that, doesn't matter. The managers have already been paid. If investors want fund managers to think about their interests, they should make the managers share the losses as well as the profits.

Providers of leverage should be extremely careful at this situation. Hedge funds will not stop after losing investor equity. They will eat right into margin debt if they are let to.

Pretty soon they will all settle into a direction opposite to that in 2004-2006. They will plow the market deep underground until they change direction again in a similarly disorderly way.

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