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“The virtuous cycle on the slow way up (the supply and demand from building spread bets
leads to tightening spreads, which in turn raises confidence to build new positions) turns
into a vicious cycle on the fast way down.”
My takeaway is that hedgies are running highly correlated strategies that make a little money most of the time (vacuuming nickels as the LTCM folks put it) but that if risk premiums expand suddenly, they'll all be heading for the exits at the same time...all suddenly correlated in the wrong direction to exit an event that all their models equally deemed unlikely.
- A clear majority of hedge funds can be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies - removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they employ extensive leverage. These spread positions do produce what look like low-risk returns most of the time — but, once in a blue moon, what are effectively options written by the hedge funds will get called. Think LTCM.
- While hedge fund strategies across the industry may look diversified, there is actually a high degree of correlation, since many funds are effectively running leveraged bets on stable or tightening risk premia. Any widening of risk premia will force large-scale liquidations of positions, with margin calls by the banks and redemptions by investors reinforcing the process.
“The virtuous cycle on the slow way up (the supply and demand from building spread bets
leads to tightening spreads, which in turn raises confidence to build new positions) turns
into a vicious cycle on the fast way down.”
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