No Hedge against the Storm

By TAN Kee Wee
(MediaCorp 938LIVE’s Money Talks, Thursday, 23 August 2007, 7.45 am and 7.20 pm)

These days, when we leave the house, we carry an umbrella, just in case it rains. What we are doing is hedging against getting wet. And the cost of our hedge is the effort of carrying the umbrella.

In the investment world, hedging is quite commonplace. However, one type of investor makes a living out of hedging positions all the time. These are the hedge funds.

The basic idea of a hedge fund is to profit when, simultaneously, a group of stocks fall in price, while another group of stocks rise in price. Profits from these trades do not depend on whether the whole market goes up or down. This is why we use the term “hedge fund”.

In recent years, many of the world’s 8,000 hedge funds have adopted the very popular “quant strategy”. Here, computer models buy and sell thousands of stocks, or just about anything else that can be traded, based on a behaviour that is supposed to be stable.

Let me give an example. Let’s suppose migrant workers on an island use telephones to speak to their mainland family members during the weekdays. During the weekends, they fly over to the mainland to join their family members. So telephones are not used during the weekends.

Because of this regular behaviour, airline sales rise during the weekends, when migrant workers fly, and fall during weekdays when they don’t fly. On the other hand, telco sales rise during the weekdays, and fall during the weekends.

Let’s now assume that the rise and fall of sales of both the telcos and airlines are reflected immediately in the rise and fall in their stock prices.

Just before the weekend begins, the computer program in a hedge fund would buy airline stocks when they are undervalued, and sell telco stocks when they are overvalued.

After the weekend, the same computer program would reverse this instruction. Such a strategy does not always guarantee profit. But over time, the winning trades will produce better-than-average returns.

For a long time, all went well for these hedge funds. Once in a hundred years, an unexpected storm will emerge and this quant strategy will fail.

In our illustration, an unexpected tropical storm struck the island during the weekend. In response, migrant workers canceled their flights. And they remained on the island and telephoned their family members.

This unexpected behaviour made airline stocks fall during the weekend when they should have risen, and made telco stocks rise when they should have fallen. As a result, the hedge funds got hit from both sides. As losses mounted, they responded by selling their shares.

Perhaps, that’s what happened last week in the global markets. It was the climax of the unexpected storm, which first started in the subprime markets a few weeks back.

The worst hour was just after Friday lunchtime, when rampant selling saw prices plunging. The markets behaved like the man who rushed to the rest room after eating too much spicy food.

The weakness of this quant strategy has since been identified, and hedge funds have adjusted their computer programs accordingly. This means that a repeat of last week’s market diarrhoea is unlikely to happen in the near future, especially after the recent US rate cut.

The road ahead may still be cluttered by debris, but a clear path is emerging. I won’t be surprised if the Straits Times Index goes back to its recent high before this Christmas.