Hedge Fund domino effect

via my hedge fund quant friend comes some articles about how the credit market problems may spillover into hedge funds which concentrate on stocks:

One theory that some on Wall Street are subscribing to says that the trouble with quants began in the credit portfolios of a few large multi-strategy quantitative hedge funds. After the subprime meltdown and the troubles at two Bear Stearns hedge funds revealed that many formerly highly rated credit products could not be easily sold in the market at the values that had been assigned to them using financial models, hedge fund managers may have realized that they were facing significant losses in their credit portfolios.

To stem possible losses, the managers sought to scale back their leverage. But selling the illiquid credit products risks uncovering even deeper losses as the credit positions were marked-to-market instead of marked-to-model, so these managers likely de-levered by selling more liquid assets—namely, US stocks.

“As these managers unwound significant factor based portfolios, these factors started to behave in unexpected and potentially troubling ways. Short names started to rally and long names started to fall as these trades started to hit the market. As most quantitative managers use similar quantitative factors, this abnormal factor phenomenon was not confined to a few funds.

As I read it, the idea here is that hedge funds are making leveraged bets on many things, including mortgages and CDO's. When those crash, they get margin calls, and have to liquidate other assets. Other assets include stat arb positions in the stock market. But the inverse of the idea that when you bet on a theory, you make the market closer to that theory is that when you sell a position you make the market *less* like the theory. So when stat arb funds liquidate, that makes all the other stat arb funds lose money, since they are all using similar strategies.

Which could make even funds with no mortgage/credit market exposure take big losses and get margin calls, thus leading to a domino effect as hedge fund after hedge fund liquidates and closes.

Not auspicious.

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