For equity market-neutral funds, there is a phrase more chilling than "worst since Lehman" and that is the quant meltdown in "August 2007" that put many funds out of business. While the mainstream media remains focused elsewhere, the last two weeks have seen equity market-neutral funds 'crash' - and today it has gotten much worse - as momentum factors diverge and memories of the 2007 bloodbath come back as this forced unwind drives the current ramp.
As detailed at the time, during the week of August 6, 2007, a number of high-profile and highly successful quantitative long/short equity hedge funds experienced unprecedented losses.
The losses at the time were initiated by the rapid unwinding of one or more sizable quantitative equity market-neutral portfolios.
Given the speed and price impact with which this occurred, it was likely the result of a sudden liquidation by a multi-strategy fund or proprietary-trading desk, possibly due to margin calls or a risk reduction.
These initial losses then put pressure on a broader set of long/short and long-only equity portfolios, causing further losses on August 9th by triggering stop-loss and de-leveraging policies.
It appears more than one quant fund is aggressively deleveraging and/or unwinding...
Chart: Bloomberg
We have been explicitly focused on the HFRXEMN - hedge fund equity market-neutral fund index - since April 2009, warning at the time that the increasingly self-confirming equity trading community was, ultimately, an unsustainable and fragile condition...
As more and more quants focus on trading exclusively with themselves, and the slow and vanilla money piggy backs to low-vol market swings, the aberrations become self-fulfilling. What retail investors fail to acknowledge is that the quants close out a majority of their ultra-short term positions at the end of each trading day, meaning that the vanilla money is stuck as a hot potato bagholder to what can only be classified as an unprecedented ponzi scheme. As the overall market volume is substantially lower now than it has been in the recent past, this strategy has in fact been working and will likely continue to do so... until it fails and we witness a repeat of the August 2007 quant failure events... at which point the market, just like Madoff, will become the emperor revealing its utter lack of clothing.
While quant funds have many factors and many styles, one of the most popular in recent years has been 'Momentum'.
Momentum-trading is the magic-sauce that makes a genius out of every trader in a bull market. The last few years have seen 'strong' momentum stocks drastically outperform 'weak' momentum stocks. However, the last 5 weeks have seen the biggest unwind of this trade since records began... as it is clear that equity market-neutral funds models are blowing up and they are liquidating...
Chart: Bloomberg
And the last 3 days have ravaged it even more as the squeeze bounce has sent every Tom, Dick, and Day-trader piling into the worst of the worst momentum stocks:
Chart: Bloomberg
So while the ramp of the last few days feels great from a headline index perspective, not only is it a squeeze of the "most shorted" stocks but a forced liquidation unwind of Momentum Long/Short funds (i.e. buying back the weakest momo names) has exaggerated the rally. Sooner or later, if this continues, as in Aug 2007, the selling pressure (and liquidity suckout) will systemically weigh on all names.