(Bloomberg) — Friday’s sudden equities rout after a months-long rally is renewing concerns that the unwinding of crowded trades could exacerbate market losses.
Before the painful selloff, stocks had been racing to all-time highs despite multiple wars and the specter of higher inflation. But with a group of semiconductor stocks driving outsized gains for the AI theme, leveraged ETF assets scaling new heights and volatility dispersion remaining elevated, questions had started to rise around concentration risk and how it could amplify the next bout of market stress.
One issue that’s become central is the very nature of the multi-strategy hedge fund model, where portfolio managers at different funds often end up clustered into similar trades. Although central risk management at the firm-level is stringent, external crowding in over-the-counter derivatives can be difficult to fully capture.
A recent paper from the hedge fund Adapt Investment Managers emphasized the crowding risk. The firm considered the hypothetical scenario of several multi-strategy pods positioned in the same trade, with a smaller pod liquidation triggering a domino effect for larger peers and exacerbating market impact as the trade unwinds.
Hedge funds now absorb a growing share of the market risk that banks used to assume. Proprietary trading firms are also entering the fray: The Dutch market maker Optiver is even setting up a specialist exotics desk to take esoteric risks off bank balance sheets.
“Hedge funds have always been active in taking on some of this risk from banks, but now they are doing it more directly because that’s where the market is moving,” said Aldo Van Audenaerde, Optiver’s head of index and rates options for the US and EMEA.
One area attracting attention is the booming structured notes market, driven in part by retail investors’ hunt for ways to enhance yield. These debt-like securities carry a performance element tied to some other assets, often an equity index or single stock, and they’re on track to exceed a record $1 trillion in total sales this year, according to data provider SP Intelligence, part of WSD. Autocallable notes stand out as the most popular, with global issuance up 45% year-on-year in the first five months, led by 64% growth from the US, the data show.
Also read: Complex Bets Slammed by Lehman’s Fall Enjoy $200 Billion Boom
Banks structuring these products recycle the risk to mitigate their exposure to volatility and dividends, among other things. Trades done as back-to-back transfers essentially separate their origination and distribution from risk taking, with hedge funds stepping in to fill the gap.
To David Elms, head of diversified alternatives at Janus Henderson Group Plc, the shift “represents the logical end point of the process” since banks seek to transfer individual risks “that caused them the most problems.” That, however, may introduce a peril to the broader system.
“One potential worry is the interaction with mechanistic and aggressive stop-loss programs, which may seek to aggressively sell complex and illiquid autocallable structures, risking risk-liquidation spirals,” Elms said. “We will only find out the holes in the back-to-back autocallable transfer model when there is a crisis.”
Antoine Bracq at R-Squared Global says hedge funds are adept at managing these kinds of risks. Individual portfolio managers operate within tight, real-time limits that are enforced by centralized risk teams, he said.
“The risk of a concentrated blow-up is materially less likely today,” he said. “The legitimate systemic question is not the pod model itself, but managing crowding and leverage at the platform level, which regulators are right to monitor.”
Before 2008, banks generally held more of the risk generated by the products they structured, using their balance sheets to warehouse exposures over time. Although they always repackaged and redistributed some of that risk, the trend has broadened in the past year or two.
As more bank alumni moved to hedge funds to set up exotic derivative desks, the financial institutions increasingly layed off the entire autocallable risk via back-to-back transactions, leaving hedge funds to manage the risk. In turn, that’s allowed the banks to offer more products to their retail clients.
“Thanks to advances in the IT ecosystem, cloud, AI and so on, exotics traders have been able to move out of banks and into multi-strategy hedge funds to manage autocallable books, in a setup that originally required multiple headcounts,” said Ramon Verastegui, founder and chief investment officer at Kairos Investment Advisors.
“This has allowed banks to transfer the risk off their balance sheets and, in turn, increase structured-product issuance to a new record high,” he added.
Of course, that could lead to a systematic crisis if different multi-strategy funds with similar positions behave in a similar way all at the same time, according to Adapt CIO Alexis Maubourguet and chief executive Clément Mary-Dauphin.
“The very risk model that underpinned their success could turn them into amplifiers of volatility in a severe or prolonged market downturn,” they wrote in a paper published in March.
While the transfer of risk is making the market healthier in a way — no single institution carries systemic concentration — hedge funds don’t have the same resources or infrastructure as banks do, warned Uriel Kutnowski, co-head of equity and derivatives at Stellar Securities.
“Unlike 2020 or 2008, the current market structure — with pods, quant market makers and recycled structured product risk — is essentially untested at scale,” Kutnowski said. “We simply don’t know how redemption pressures, margin calls and gamma unwinds interact in that environment.”
More stories like this are available on bloomberg.com
About The Author
