Some Hedge Funds “Hedged” During Stock Market Sell Off, Others Not As Risk Focused

With the VIX index jumping 120 percent on a weekly basis, the most in its history, and with the index measuring volatility or “fear” up near 47 percent on the day, one might think professional investors might be concerned. While the sell off did surprise some, certain hedge fund managers have started to dip their toes in the water to buy stocks they have on their accumulation list, while other algorithmic strategies are actually prospering in this volatile but generally consistently trending market.

Stock market sell off surprises some while others were prepared and are hedged prospering

While some might be shocked by a weekly stock market decline at near six percent, certain market observers have a different view. “The six year bull market is the anomaly, today’s market decline is not the anomaly,” Fox Business News anchor Deirdre Bolton told ValueWalk after having spoken with her fund manager contacts.

S&P 500 started Monday, August 17 at 2089, and approaching this week’s close the S&P 500 now stands down more than 100 points at 1988.  “This is a risk off environment. What we are witnessing is a de-risking,” she said, pointing to the VIX volatility index as at its highest point since October 2014. “When people are anxious they want more liquidity.”

Markets had exhibited odd algorithmic patterns during the quantitative easing period and this week, while some headline markets predictably correlated to one another (stocks in one direction, gold and bonds exhibiting negative correlations to stocks). In such an environment, observers noted the VIX index was in backwardation during part of the week, with August trading lower than the spot price but with September and the balance of the time horizon. This has occurred in the past, perhaps most notably in 2012 during the threatened government shutdown and budget battle. While the pattern was different in 2012, it was then viewed as an indicator of algorithmic concern over market events as past performance of the backwardation situation is considered a tail event without a large study sample set.

As industrial commodities dropped perspicaciously during the week — oil broke the $40 level Friday before climbing above that level and copper has been looking weak all month, in a strong downtrend — certain algorithmic traders considered the impact on inflationary expectations. “Ominously, the sharp drop in inflationary expectations often precedes and/or accompanies a liquidity crisis,” said Jay Feuerstein, managing director of the Alternative Strategies Group at Manning & Napier. Feuerstein is credited with having helped develop the original U.S. Treasury futures contract. “With rates so low, the markets are concerned that the Fed does not have the tools to deal with any crisis that might arise. Further, the weakening of the dollar in the face of the equity sell off says that the U.S. will suffer more than the rest of the world and might be forced to make a quick “about-face” early next year towards a more accommodative stance.”

Certain analysts point to longer term interest rate concerns as the weekly cause for concern, while Bolton points to China as the primary performance driver in Friday’s sell off. After weak manufacturing numbers were released, Chinese stocks sold up — leading the European equity traders selling as well as U.S. investors.

“The key here is inflationary expectations,” Feuerstein said. “Forward five-year break even inflation has fallen to the lowest levels since the crash of 2008. At that time, expected five-year inflation fell from over three per cent to .76 per cent. It subsequently rallied to 2.72 by per cent by 2011 but has fallen steadily ever since. In the past two months, inflationary expectations have fallen precipitously 2.07 per cent to just 1.72 per cent. This means that expected inflation over the next five years is just 1.72 per cent per year. This is well below the Fed target of two per cent, and predicts that Fed tightening will be short-lived.

Bolton: September rate hike now unlikely, Feuerstein disagrees

Bolton is suspicious of early Fed tightening and is decidedly a “Decemberist” in terms of Fed rate hikes. She thinks market sentiment has shifted in a short period of time, pointing to a significant sell off in Fed futures from probability of a hike in Sept falling to 28 percent, down from down from 42 percent earlier in the week. She also points to talk among bank analysts that she says have started to change their outlook and think increasingly the Fed is backed into a corner and is unlikely to raise rates in September. Feuerstein, disagrees. “I believe the Fed will raise rates next month and again in December, hoping that the markets will calm themselves once the rate hikes occur. Inflationary expectations are saying the markets will be anything but calm.”

Fund managers have been hedging

Experienced fund managers Bolton speaks with have been hedging their portfolio over past few weeks, with the VIX being the most natural method to do so. Such a hedging tactic bore fruit this morning when weak Chinese manufacturing numbers led to a morning sell off in Europe with U.S. shares catching the same cold. The VIX index ended up near 25 percent.

Other traditional safe harbors during times of market uncertainty have been performing positively on the week. The Newedge CTA index, for instance, was up every day but one this week coming into Friday. When markets engage in sharp but steady price movement in any one direction – up or down – managed futures trend followers have performed positively in the past. During 2008, for instance, the noncorrelated strategy was up near 20 percent depending on the index one follows. In volatile markets Bolton likes long / short hedge fund strategies to minimize volatility. Special situation strategies remains attractive but those strategies remain illiquid and institutional investors want a degree of liquidity.

Other institutional investors with whom ValueWalk spoke with like managed futures in markets where trends consistently move in one direction, either down or up in price. This is considered a “liquid alternative” and such a strategy might fit in with today’s market action. Institutional investors Bolton speaks with say they want to be liquid, as the points to $8 billion in recent money market inflows, levels not seen since 2012. Bolton noted that “even previous metals, including gold, have seen high inflows of about $18 million,” which on a relative basis is a high percentage move.

Bolton: brave hedge fund managers have been buying the lows

While the stock market may be experiencing a value adjustment, the silver lining that people Bolton speaks with point to is the U.S. housing market.  After speaking with real estate mogul Larry Silverstein this morning, Bolton noted to strong demand for real estate and deal flow, particularly in New York. Positivity on buying during a value adjustment vary, with some algorithmic players looking for a potential 7 to 10 percent decline to then watch for a turnaround. Bolton is speaking with fund managers who like the market environment now, however. She speaks with are looking at single name stocks they had on a list and many of those stocks are entering pre-defined buying regions. Bolton spoke to one fund manager who recently purchased Twitter Inc (NYSE:TWTR) at $30 earlier in the week and is expecting a mean reversion. The stock is currently trading near $26. Another fund manager today established a position in Facebook Inc (NASDAQ:FB) calls rather than add long exposure through owning the physical stock. This presents a different risk profile and the investor will nonetheless make money on the calls if the stock goes higher.