Hedge Funds and Risk Tolerance

With the low volatility, the day to day trading edges are very slim.  Sure, these days there are a few small cap speculative stocks where you have insane and irrational moves, but there are lots of trading frictions in those markets, the difficulty in finding borrows, exorbitant borrow fees, extreme tail risk, and lower liquidity.  The liquidity is the big thing.  You can't move large size easily in small cap stocks, which limits the scalability of a strategy.  So that pretty much leaves either large cap stocks or futures/options.  Since the large cap stocks provide little leverage, futures/options are a much more attractive area for speculative trading. 

I recently heard that hedge funds are making a comeback, with inflows over $80B this year.  I also noticed that their YTD returns are 5.1%.  The SPX is up 12% this year.  Bonds are also up.  Once again, a simple 60/40 stock/bond risk parity strategy which can be put on for near zero fees is beating the hedge funds again.  I recently saw that a hedge fund of funds manager, Mark Yusko, made a bet with Warren Buffett that he could beat a SPX index fund in 10 years, net of fees.  I think Yusko will lose that bet.  Just because of the fees.  Even with the SPX highly overvalued, hedge funds are basically a more costly, lower beta play on the stock market. Hedge funds don't really provide alpha anymore, just damped down beta covered in a thin veil of secrecy to protect their 2 and 20 business model. 

The reason I bring up hedge funds is because they are the main reason there are short term market dislocations.  If you take away hedge funds, that removes a lot of the speculation in the futures and options space.  Most of the money going into mutual funds and ETFs don't make big bets on FX, interest rates, and commodity prices.  The hedge funds are there to provide more fuel to the fire, making trends last longer, going to prices they probably shouldn't go to. 

Most hedge funds in the futures space are trend followers, so in general, they will blindly buy strength and sell weakness.  In the past, when trends lasted a long time, it was a good strategy.  Nowadays with so many following the same strategy, as well as low inflation and money printing central banks, you don't have as many long term trends in FX, interest rates, or commodities.  So they have been getting churned and burned since 2008. The returns of the Barclays Hedge CTA index (survivorship bias inflates these returns) is basically flat since 2008, while the S&P has gone up over 200% in the same time period. 

These CTAs built up a lot of their record when the futures markets tended to have long trends, and before their strategy got overpopulated, splitting what little edge they got from following the trend with other hedge funds.

Whether it is hedge funds liquidating positions that have gone bad all at the same time, or piling into a position with a herd mentality, there are opportunities created in their trading.  But the only real way to capture those opportunities is to extend your time frame beyond the hedge funds' time frame.  The hedge funds' time frame is constrained by their inability to accept big losses, since institutions don't want a lot of volatility in a fund's performance. 

This is their big handicap. Risk tolerance.  Hedge funds cannot withstand big drawdowns, which means they have to cut their losses before they get too big.  This creates opportunities during their liquidations, because often, they are liquidating not because they suddenly discovered a fundamental change in the market, but because they hit their loss limit on the position and they had to get rid of it.  That is where the opportunity lies.

On the other hand, the individual trader can trade more aggressively and trade more optimal size because they can weather big drawdowns and don't have to worry about redemptions.  They don't have to puke out their positions as much.  Yes, sometimes the individual gets a trade wrong and has to get rid of it, but it should be based on criteria of market behavior and price action, not a loss limit.  Remember, the fastest way to grow your account size is to follow the Kelly criterion.  This exposes your account to big drawdowns, because you are betting your edge, basically. A 10% edge on a 1 to 1 bet calls for a 10% bet. A 99% edge on a 1 to 1 bet calls for a 99% bet! 

Most hedge funds can't bet that way.  They are reluctant to lose more than 2% on any one trade.  That is a big disadvantage.  They follow a much, much less risky money management strategy, which while safer, offers much lower potential returns.  This is why I believe profitable traders are much better off accumulating their own capital and trading it aggressively, rather than try to gather assets and trade more capital, but in the process be pigeon-holed by their investors' lack of risk tolerance.  Plus, its a headache dealing with all the paperwork and regulations of managing a fund.

I expect the hedge funds to be the ones to push this equity market towards its ultimate top, taking prices too high.  I also expect them to be the ones who liquidate their positions en masse as the trend changes.  That is what you saw in 2015/2016, and I think you see that again in 2018.