Hedgies Load the Boat

February 24, 2011
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Is this some classic timing or what. Bloomberg reports hedge funds have borrowed the most since 2007 to make leveraged long equity bets:

Hedge funds increased their net leverage in January to the highest level since October 2007, as they took advantage of record-low borrowing costs to bet that the U.S. equity rally will continue.

Debt at margin accounts at the New York Stock Exchange minus cash and unused credit from margin accounts climbed to $46 billion, according to data released by NYSE yesterday. Hedge funds had $290 billion of debt from margin accounts in December, the largest sum since Lehman Brothers Holdings Inc. collapsed in September 2008.

“It makes a lot of sense given the low cost of borrowing and some equities’ valuations,” said Patrick Armstrong, who helps manage $356 million in multiasset strategies at Armstrong Investment Managers LLP in London. “There is a capital- structure arbitrage to be made by buying stocks with leverage…

Ah yes, gotta love those arbitrage guys. They take their volatility all at once. Pigs get fat but hogs get slaughtered, and anyone doubling down in January likely isn’t taking a hard look at risk.

In addition to leveraging up in the face of severe geopolitical headwinds, there is the risk of “portfolio contagion” to think about. Portfolio contagion occurs when a large number of players face losses in the same concentrated areas, and are then forced to cut back in other, unrelated areas of the portfolio as a means of stopping the bleeding.

When portfolio contagion reaches an extreme, positions that have no logical relation to each other apart from their “hedge fund hotel” status can experience vicious sell-offs in tandem. Such effects can further be enhanced earlier in the calendar year, as most hedge funds start from zero (in performance terms) and have less margin for error.

Remember that markets obey power laws — as with earthquakes and forest fires, the sell-off itself doesn’t know how big it will be. This bit of news just makes the present situation all the more intriguing.

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