The Achilles Heel Of Hedge Funds

by Geoff Garbacz | 06/13/2020 7:07 PM

Rebel Yell Morning Market Report

Your Daily Financial Market Briefing - Giving You An Investing Edge Before Each Trading Day Begins

The Achilles Heel Of Hedge Funds

The headline may be a bit dramatic but it is no doubt correct. The idea of a long/short fund is a great idea in practice but then reality hits of shorts rising faster than the longs after a quick selloff, correction or bear market. As Mike Tyson said, "everyone has a plan until they get punched in the face".

The latest example of getting punched in the face is Renaissance Capital. This morning a client sent me an article from The Financial Times about the latest blowup. During the first week of June, the Renaissance Technologies Institutional Diversified Alpha Fund declined 8.8% and for the year is down 20.7%. Meanwhile, the S&P 500 the first week of June rose 4.91% and the Russell 2000 rose 8.11%.

This drawdown by Renaissance is really interesting to me given that over Christmas of 2019 I read The Man Who Solved The Market. The book is about Jim Simons and how he built Renaissance. The fact that they are struggling now is not really a surprise as the book detailed troubles the fund had as it grew over time and markets changed. (By the way, this book is a must read for anyone in the market and Simons noted that all models fail at some point and nothing is flawless).

I would be willing to bet that the 8.8% lose for June by Renaissance is much greater after this week even with Thursday's 1900 point drop on the Dow. Why? Read on and you will understand why.

Clearly, the fund did not lose money on the long side in early June but rather the short side. You see Renaissance got caught in a dreaded Long/Short Tsunami squeeze. 70% of the time this squeeze is caused by shorts rising greater than longs. 30% of the time the longs fall at a greater rate than the shorts. There have been 113 Long/Short Tsunami Squeezes since the beginning of 2010. The blame lays on the long side 35 times and on the short side 78 times.

In 2020, there were no Long/Short Tsunami events prior to the week of 3/23 to 3/27. Then boom they began to hit, fast and furious. That was the week that the S&P 500 and other equity indexes bottomed on Monday 3/23. For the week, heavily shorted stocks where the shorts had been making money rose 16.67%. Stocks that were already in short squeezes rose 7.25%. The difference was a loss of -9.42%. Pretty dramatic but that is what happens in a Long/Short Tsunami week.

The week of 3/23 to 3/27 was as not much a short squeeze as much as its was a week where the shorts decided to lock in their gains from the peak in February to the March low. The second Tsunami week in 2020 happened in the shortened Easter trading week of 4/6-4/9. That was also about shorts taking profits after cleaning up the week of 3/30-4/3 when they made 10.42% on the short side.Simply a case of the roach motel at work, where you can check in but checking out is impossible.

Since 4/9, there have been five more Long/Short Tsunami weeks including four in a row with the week just ended at the tail end. Make no mistake about it these have been brutal short squeezes against the backdrop of a Federal Reserve that will use its complete power. The longest such prior streak was in April of 2016 and it cost Long/Short funds a pretty serious drawdown of -7.34%. This drawdown has cost Long/Short funds -28.28%. Brutal.

"Don't you know that life is like a military campaign? One must serve on watch, another in reconnaissance, another on the front line...So it is for us- each person's life is a kind of battle, and a long and varied one, too."

The writer of the above was the great slave turned philosopher Epictetus and though it was written long ago never has it been more applicable than right now. Each fund that offers a long/short product as well as a long only product needs a tool set for those "on watch" for the incoming tsunami. Without it, struggles like Renaissance are guaranteed.

As such we and our clients were well prepared for the events of the last two months since the low of March 23 as well as the drop from the February peak. To conclude Epictetus noted:

"In this way you must understand how laughable it is to say"Tell me what to do! What advice could I possibly give? No, a far better request is, "Train my mind to adapt to any circumstance."...In this way, if circumstances take you off won't be desperate for a new prompting."

This year has been an off script one for sure and training the mind is key to any research effort to be ready for sudden shifts in the market. We can help you retain that mind.

Latest Reports

Stay Up to Date With The Latest
News & Updates

Join Our Newsletter


Rebel Yell Morning Market Report
Market Alerts
Offers from us
Offers from our trusted partners

Follow Us

Connect with us on social media

Facebook Twitter