Tue, Mar 20, 2018
Welcome Guest
Free Trial RSS
Get FREE trial access to our award winning publications
Opalesque Futures Intelligence

Futures Lab: Same net exposure, same risk? No, says Jon Sundt. See his example of a quant fund, based on the "perfect storm" of August 2007

Tuesday, July 27, 2010

Jon Sundt

Understanding Quants' Hazard

As investors consider riskier assets, it may be useful to recall a lesson from three years ago. The following parable is from an August 2007 newsletter sent to clients by Jon Sundt, president and chief executive of Altegris Investments, an allocator to hedge funds and commodity trading advisors.

The example was inspired by the steep losses suffered by quantitative traders in August 2007. It is from real experience, but Mr. Sundt used fictional names for the two funds he compared, PhD Fund and Plain Vanilla Fund.

Both funds are market neutral and go long and short US equities. Both have stellar track records, low correlation to the S&P 500 and reasonable performance in up and down markets

By 2007, low volatility had lulled many quant shops into a false sense of security. The lack of any recent blowups or spikes in volatility made them feel immune to market jolts. At the same time, quantitative models were picking up nickels where they formerly picked up quarters. Because the models would need to pick up more nickels to make the same amount of money, many turned to leverage for help.

The PhD Fund had run its models over the past five years and made a killing. Its managers were rich. They had found that because of the low volatility in the market and the low correlation within their market-neutral system, they could leverage their fund.
So they decided to lever eight to one. For every $1 million the Fund put forward, it borrowed enough to have $4 million for its long book and $4 million for its short book, staying with the "market neutral" label.

This was genius! The PhD Fund amplified returns, all the while keeping its market neutral hat on. It had $1 billion under management before leverage. With leverage, its assets were $8 billion. Its net exposure was zero ($4 million long plus $4 million short), but its gross exposure was 8x.

For comparison, consider the Plain Vanilla Long Short Fund, with around $400 million under management. It has an experienced research team that evaluates fundamental measures of a company's stock (bottom-up research) as well as overall industry trends (top-down research). The team buys what they believe are undervalued stocks and sells what they believe are overvalued stocks.

The Vanilla Fund's team trade 50 positions long and 50 positions short. They keep their book market neutral, so their net exposure is zero. They do this by using the regular margin available for many brokerage accounts. The Vanilla Fund borrows $1 million for every $1 million dollar invested, meaning it uses $1 million to go long and $1 million to go short, for a gross leverage of 2x. With leverage, the Vanilla Fund has $800 million under management.


The Vanilla Fund and the PhD Fund both have zero net exposures...for every dollar long they have a dollar short. Combine this with their performance, and they look pretty similar. But that is a wrong perception.

The difference is seen by looking at the funds' gross exposure. Here the differential is huge: 200% for the Vanilla Fund compared to 800% for the PhD Fund (chart). Gross exposure shows just how leveraged these funds are: 2x versus 8x.

During a few days in August 2007, there was an extreme event in the stock market. In particular, the stocks bought vs. short sold by quant funds went through a sharp reversal. Because many funds had similar positions, they drove the market down as they tried to liquidate holdings.

The PhD Fund suffered a 4% loss on the longs and a 4% loss on the shorts. But that was before the leverage. Because of the leverage, you have to multiply it by eight, for a 32% loss! The Vanilla Fund also lost money that month, but less.

The moral: Net exposure can be misleading. One has to pay attention to gross exposure.

This article was published in Opalesque Futures Intelligence.
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Opalesque Futures Intelligence
Today's Exclusives Today's Other Voices More Exclusives
Previous Opalesque Exclusives                                  
More Other Voices
Previous Other Voices                                               
Access Alternative Market Briefing

  • Top Forwarded
  • Top Tracked
  • Top Searched
  1. John Paulson, once the industry's largest hedge fund, to return some investors' money[more]

    Komfie Manalo, Opalesque Asia: John Paulson is reported to be retuning some of his investors' money as a number of his hedge funds continue to suffer setbacks, reports

  2. Investing - Hedge funds amass big bets against world's leading advertisers, Investor Elliott Management buys tiny stake in Wipro[more]

    Hedge funds amass big bets against world's leading advertisers From FT.com: Hedge funds have amassed bearish bets of more than $3bn against the world's largest advertising companies in an attempt to profit as the industry undergoes ongoing wrenching disruption and slowing growth. Funds i

  3. News Briefs - Investcorp to launch a $100 million PE fund for Omani pension funds[more]

    Bahrain-based investment firm Investcorp will soon launch a $100 million fund dedicated to Oman's Pension Funds as part of its investment plan. 'The Opportunities Fund' will be focused on private equity investments in the U.S. and Europe and will target mid-sized companies across a broad range of se

  4. DoubleLine's Gundlach sees U.S. 10-year Treasury yield rising, weighing on stocks[more]

    From Reuters/Streetinsider.com: Jeffrey Gundlach, the chief executive of DoubleLine Capital and known on Wall Street as the "Bond King," said on Tuesday the yield on the U.S. 10-year Treasury note will likely move higher and pressure riskier assets including equities and junk bonds. Gundlach, on an

  5. SEC charges Theranos CEO Holmes with fraud[more]

    Bailey McCann, Opalesque New York: The SEC has charged Elizabeth Holmes, founder and CEO of Theranos and its former President Ramesh "Sunny" Balwani with raising more than $700 million from investors through an elaborate, years-long fraud in which they exaggerated or made false statements about t