Market Turmoil Hits Hedge Funds Hard

07/31/2007 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, chairman and chief investment officer of Schaeffer's Investment Research, says many hedge funds may have found themselves on the wrong side of last week's big selloff.

The fierce gyrations of the markets left even some of the most experienced traders clutching their stomachs last week. When the dust finally cleared after the close on Friday, the Dow Jones Industrial Average (DJIA) had dropped 4.23% from the previous Friday's close, while the Standard & Poor's 500 index (SPX) shed 4.9% and the NASDAQ Composite index (COMP) had dropped 4.67%. [The week following options expiration] remains a major challenge for the market, as 12 of the past 19 post-expiration weeks have been negative since January 2006, a period of rising stock prices.

However, the true whipping boy for the week proved to be the [small-capitalization] Russell 2000 Index (RUT), as it relinquished a whopping 7.01%. What's more, the iShares Russell 2000 Index Fund (IWM) is now 10.9% off its July 19 peak.

According to Alternative Investing News, Stonebrook Structured Products, a major provider of hedge fund replication strategies, states that "a large part of hedge-fund returns are driven by shorting large-cap growth and the going long small-cap value and emerging market equity."

In other words, as long as small-cap stocks were outperforming the S&P 500, the hedge funds could generate decent returns. But once the more volatile smaller-cap stocks began to seriously underperform the S&P, their short S&P hedges were not sufficiently protecting them. 

My guess is that with the recent plunge in the RUT, most long/short equity funds are now seriously in the hole vs. the S&P for the year. And if the market now rallies from here, they've just gotten themselves into more trouble by adding to their hedges via IWM puts or IWM shorts.

(The IWM saw record put volume on Thursday, as nearly 1.3 million puts changed hands. This figure easily blows away the other two top volumes of roughly 975,000 contracts on June 8, 2006 and more than 964,000 contracts on February 27, 2007.)

The bottom line is that while the "bad market breadth" on this correction is disquieting to many and is a signal of a potentially bullish oversold condition to others, it may indicate nothing more than a "hedge fund puke" that could be reversed in a heartbeat should the market begin to stabilize.

One sign of the fear swamping the market was the sharp jump in the CBOE Market Volatility Index (VIX) last week. The index spiked more than 42% from the previous Friday's close and took out its June 2006 highs when it closed on Friday at 24.17.

Fear is running high, [which isn't] unwarranted as the week still holds a few potential stumbling blocks for the market. A number of key economic reports could incite some selling fervor, only to culminate in the major report of the month-nonfarm payrolls.

Along with economic data, the week remains heavily laden with earnings reports, adding a second layer of potential volatility. While the current pullback may not have yet put in a bottom, the broad market is still clinging to year-to-date gains, and long-term support levels are holding.

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