When traders sell what they can rather than what they should, once-reliable investment strategies unravel
By Jacky Wong
Shares in Japanese wireless carrier NTT DoCoMo hit their highest price since 2002 on Thursday.
Photo: Kiyoshi Ota/Bloomberg News .
When everyone runs for the exit at the same time, the stampede can be brutal. The recent market rout has turned some seemingly low-risk trades into hazardous traps.
One example is so-called relative-value trades, where investors buy one security while shorting another, trying to exploit pricing anomalies. Some trades are based on statistical analysis, while others rely on fundamental linkages between two instruments, such as futures and their underlying asset.
These strategies are usually seen as market neutral—they can make money whether the market is up or down—because the net exposure is small. Data tracker Hedge Fund Research said $877.3 billion of assets were managed under the relative-value umbrella as of December.
But when investors are scrambling for cash, the supposed pricing anomalies can be amplified, especially since no one is willing to step in to correct the valuation divergence. For example, in fixed income, the spreads between bond futures and the underlying bonds have widened, perhaps because futures are the more liquid instrument of the two.
That has driven some funds to liquidate their positions, which has further pushed the spreads out of whack and caused more funds to cut their trades in a vicious spiral.
Similarly in equities, funds, especially in Asia, would buy a stock and simultaneously short its parent or subsidiary to bet on the convergence of their values. These values, however, can diverge further when everyone is closing the same trades. In one extreme example, shares of Japanese wireless carrier NTT DoCoMohit their highest price since 2002 on Thursday.
The likely reason for the pop is that investors who had shorted the stock and bought its parent Nippon Telegraph and Telephonewere unwinding the trade, pushing others to make the same move. Until last Thursday, DoCoMo had been up 12% this month, while its parent was down 4%.
Betting on the closing of a merger—curiously named risk arbitrage—has also had some bad days. Such a strategy may be largely market-neutral in normal times, but the sudden economic downturn poses some real risks to the completion of deals, especially if they are funded by debt.
Shares in casino operator Caesars Entertainment are now trading 35% below the acquisition price offered by Eldorado Resorts.The discount was as high as 61% last week, having been virtually zero in February.
The fact that many such trades are financed by leverage to juice returns has made the fallout worse. The use of debt to enhance yields is probably the reason why some theoretically more stable sectors like utilities have actually performed worse than the broader market in the current bear market, for example.
Some trades that make sense normally are turned upside down in a crisis, when traders don’t sell what they should but what they can.
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