The underlying issue with many hedge funds has been consistent and can be summarized in one word: Leverage. In its simplest definition, leverage is when a firm borrows money from a bank or financial institution and utilizes the borrowed money to increase potential return. The perils of leverage have recently exposed firms and can be especially worrisome when used to a large degree or with a concentrated position. It’s all fun and games until the trade moves against you and afterall, a levered bet could result in unlimited downside risk.
In terms of the Gamestop story, various hedge funds sold the stock “short”, placing a bet that the stock’s price would decline. Subsequently, traders took advantage of the heavily shorted stock and piled into the position causing a short squeeze and an unwinding of the hedge funds’ bets (For more detail on how this works, read our Gamestop post). As a result, hedge funds suffered large losses, having to buy back the stock at a much higher price.
The story behind the collapse of Archegos Capital Management shares a similar theme. The hedge fund was heavily levered, putting up only small deposits for the money it was borrowing. When that borrowed money was deployed for an investment that recently came tumbling down, Archegos Capital Management was left exposed, as investment banks requested margin calls that the hedge fund could not cover. The sharp decline in ViacomCBS when the stock’s value was cut in half in less than one week, was one of the main contributors to the fund’s collapse. The hedge fund used derivative contracts allowing it to avoid disclosing its positions, until this was uncovered by the sharp stock selloff. This practice is not uncommon for hedge funds nor is it unlawful. However, it does beg the question: how many other hedge funds out there are one margin call away from failure?
Hedge funds, by nature, use leverage to increase their potential return. Of course, with the increased potential upside, comes increased potential downside risk as well. Unlike a mutual fund, hedge funds do not have to disclose their positions. It is this lack of transparency that may be of concern. When hedge funds are unable to put up collateral upon a margin call, the lender, often investment banks, cover the shortfall. In essence, the burden trickles into the financial system and with the lack of transparency, it is difficult to know the potential impact of hedge fund failures on the broader economy. In the case of Archegos Capital Management, it seems to be an isolated incident. But what if multiple hedge funds found themselves in similar circumstances at the same time? We can’t help but think back to the 2008 housing bubble and bank failures that nearly took place.
Perhaps greater transparency into the HF’s could help mitigate their risk of failure and avoid similar outcomes to that of Archegos. Surely regulatory changes will follow.