'What has changed though is the increased dollars managed by these funds [now > $3.5T] and the concentration, of these dollars, at the twenty largest funds [top heavy for sure]. What has also considerably changed is the cost of money … aka leverage. It is just so much cheaper … and, of course, is still being liberally applied but, to reiterate, in fewer hands.
Are these “hands” any steadier than they were ten years ago? I suppose that is debate-able but my bet is that they are not. They are still relying on regression-ed and stress tested data from the past [albeit with faster computers & more data]. They may even argue that their models are stronger due to the high volatility markets of ’08/’09 that they were able to survive and subsequently measure, test and integrate into their current “Black Boxes” … further strengthening their convictions … which is the most dangerous aspect of all.
..
..the initial catalyst is liquidity [which typically results in a breakdown of historic correlations as the models begin to “knee-bend” … and the perceived safety of hedges is cast in doubt] followed by margin calls [the ugly side of leverage … not to mention a whole recent slew of ETF’s that are plainly levered to begin with that, with the use of borrowed money..'<blockquote>'I recently listened to a podcast with some all-star [there are awards for everything now] “Black Box” equity trader. It was quite a “telling” interview & I thank him for his insights but I’d heard it all before. His confidence was staggering considering the general unpredictability of the future and, of course, the equity markets. He explained how he had completely converted from a generally unsuccessful, discretionary technical trading style to a purely quantitative and scientific trading mode. He seemed to be so excited that his models, according to him, were pretty much “bullet proof”. Having had more than just some tangential experience with black box modeling and trading myself I thought … you know … some people will just never learn.
..
So, given all of this, what types of annual returns could these portfolios actually generate? A very good model would generate a net 5-7% … but 3.5-5% was acceptable too. So how then could anybody make any real money especially after considering the labor costs to construct/manage/monitor these models … which … BTW … was substantial?
Of course there was only one real way … although it would incrementally cut into performance even more, in the near term, but ultimately pay off if the “live” model performed as tested. The answer =
LEVERAGE … and I mean a lot of it … as long as the volatility was low enough.
Back-tested volatility was one thing and live model volatility was another thing so leverage was only, ever so slowly, applied … but as time passed and the model performed, the leverage applied would definitely increase. Before you knew it those 5% returns were suddenly 20-25% returns as the positive beauty of leverage [in this case 4-5x] was unleashed.
Fast forward 10 years and the objectives of hedge funds are still the same. Generate positive absolute returns with low volatility … seeking the asymmetrical trade … sometimes discretionary but in many cases these “Black Box” models still proliferate. And BTW … they are all “
doing the same thing“ as always … current iteration = levered “long” funds.
What has changed though is the increased dollars managed by these funds [now > $3.5T] and the concentration, of these dollars, at the twenty largest funds [top heavy for sure]. What has also considerably changed is the cost of money … aka leverage. It is just so much cheaper … and, of course, is still being liberally applied but, to reiterate, in fewer hands.
Are these “hands” any steadier than they were ten years ago? I suppose that is debate-able but my bet is that they are not. They are still relying on regression-ed and stress tested data from the past [albeit with faster computers & more data]. They may even argue that their models are stronger due to the high volatility markets of ’08/’09 that they were able to survive and subsequently measure, test and integrate into their current “Black Boxes” … further strengthening their convictions … which is the most dangerous aspect of all.
Because …
<blockquote>
1. Strong Conviction … aka Over Confidence +
2. Low Volatility +
3. High Levels/Low Costs of Leverage [irrespective of Dodd-Frank] +
4. More Absolute Capital at Risk +
5. Increased Concentration of “At Risk” Capital +
6. “Doing the Same Thing”
</blockquote>
… Adds up to a
Combustible Market Cocktail.Still a catalyst is needed and, as always, the initial catalyst is liquidity [which typically results in a breakdown of historic correlations as the models begin to “knee-bend” … and the perceived safety of hedges is cast in doubt] followed by margin calls [the ugly side of leverage … not to mention a whole recent slew of ETF’s that are plainly levered to begin with that, with the use of borrowed money, morph into “super-levered” financial instruments] and concluding with the ever ugly human panic element [in this case the complete disregard for the “black box” models even after doubling/trebling capital applied on the way down because the “black box” instructed you to]. When the “box” eventually gets “kicked to the curb” … that is when the selling ends … but not after some REAL financial pain.
So can, and will, this really occur once again? It can absolutely occur but it is just impossible to know exactly when … although there are plenty of warning signs suggesting its likelihood … as there have been for some time.
However, I am quite confident of the following:
<blockquote>
1. The Fed Is Clueless On All Of This[just too many moving parts for them … they cannot even coordinate a simple “cover-up” of leaked monetary policy … so no way the academics can grasp any of this … just liked they missed LTCM. Nor it seems…do they have any interest in it as it is too tactical for a strategically inclined central banker].
2. “Eventually They ALL Blow-Up” The Only Real Question Left To Answer =
HOW BIG CAN THIS POSSIBLE “BLOW-UP” ACTUALLY BE? I think … if the pieces simultaneously shudder … then pretty BIG.</blockquote>
- Dominique Dassault,
Black Box Trading: Why They All “Blow-Up”, June 26, 2015</blockquote>
Context<blockquote>
'..memorable peers that include 1906, 1929, 1937, 1966, 1972, 2000 and 2007 .. this moment as historic..'' “Monetary policy… after all, is extremely important” – is an understatement.' - Doug NolandBanking Reform - English/Dutch) '..a truly stable financial and monetary system for the twenty-first century..'</blockquote>