What the Archegos hedge fund blowup can teach us

Impressive economic data and market optimism drove markets higher last week. The S&P 500 Index and Nasdaq index ended the week +1.14% and +2.60% last week and 7.02% and 4.59% year to date. Locally the Hang Seng Index also saw an uplift +2.13% last week and +6.27% in 2021. Although tech stocks benefited last week with the vaccine-led prospects of that COVID-19 may be starting to be behind us, investor rotation into lagging sectors (that underperformed previously) is becoming more and more apparent.

AQUMON’s diversified US ETF portfolios were +0.06% (defensive) to +0.64% (aggressive) last week and -0.34% (defensive) to +4.21% (aggressive) year to date. AQUMON’s SmartGlobal HK ETF portfolio, with more regional exposure to Hong Kong/China, was -0.01% (defensive) to +1.02% (aggressive) year to date. Most asset classes rebounded last week with Hong Kong tech stocks (+5.27%), US small caps stocks (+1.59%) and emerging market stocks (+1.19%) leading the way.

AQUMON’s newly launched SmartStock thematic stock portfolios also had a strong rebound week. Last week, the best performer was Quality Blue Chip (Chinese A-share stocks) portfolio +4.97%, while the worst performer was the Profit Makers (US stocks) premium portfolio at +0.87%. Year to date best performer was Global Tech Giants (US stocks) premium portfolio +5.57% and worst performer was the Hidden Gems (Chinese A-share stocks) portfolio at -6.50%.

AQUMON SmartStock portfolios will be launching a number of new exciting themes by next week (April 12th) which include medical, Environmental Social Governance (ESG), high dividend stocks, Real Estate Investment Trust (REIT) stocks and more!

Chances are if you have been reading financial news lately you will have heard a relatively lesser known New York hedge fund called Archegos (pronounced "Ar-chee-gos" ) Capital Management suddenly blew up and forced a number of the Wall Street banks to ‘fire sale’ US$30 billion (~HK233.3 billion) of stock within a matter of days. We think this is a teachable moment for investors and this will be the focus for our Market Insights this week. 

So what exactly happened?

In the past 2 weeks globally financial markets were rocked by the news of a hedge fund blowup due to taking on excess leverage (meaning they used a lot of borrowed money to fund their investments). What was unexpected was how a lesser known hedge fund named Archegos who managed US$10 billion (~HK$77.8 billion) in assets was able to accumulate under the radar approximately US$100 billion (~HK$777.6 billion) in stock positions based on borrowed money. If you do the math this implies they had 10 times leverage (meaning for every $1 they had they borrowed $10 to invest).

Furthermore, Archegos positions were betting via more complex derivative investment products that its largest stocks positions such as Viacom, Discovery and many US-listed Chinese stocks would rise in pricing but sadly that came to a screeching halt Monday last week. 2 weeks ago one of its key stock positions in media company Viacom announced a US$3 billion (~HK$23.3 billion) stock sale coupled with stock analyst downgrades caused the stock to quickly plummet in pricing.

With Viacom’s stock down 20% in a matter of days Archegos was on the hook to pay more than US$10 billion (~HK$77.8 billion) in margin calls. Margin calls are when an investor’s account falls below a required amount and the investor needs to deposit more money to return the account back to the minimum amount level. When Archegos failed to pay the banks who loaned them to money to invest, the banks were forced to sell over US$30 billion (~HK233.3 billion) of stock that was tied to Archego’s portfolio in a matter of days.

The result of the forced sale was multiple banks such as Credit Suisse, Nomura and others were on the hook for losses to be in the US$5-10 billion (~HK$38.9 - HK$77.8 billion) range as estimated by JP Morgan. This was the main reason why the US stock market was quite choppy the past 2 weeks. 

Wait, so what exactly are hedge funds?

Hedge funds are more sophisticated investment firms that use more complicated investment strategies with the goal to achieve higher than normal returns (but risk level may also be higher). Normally mutual funds can mainly only buy investments and achieve gains from the asset increasing in pricing. Hedge funds in comparison, using more diverse investment strategies, can potentially profit even if an asset falls or has no change in price. Furthermore hedge funds can invest into not just public assets (like stocks, bonds etc) but also in private or less common assets (derivatives, private companies, real estate etc). Hedge funds also aim for more professional-level investors and are generally more lightly regulated than a regular mutual fund.

What are these complex investment products Archegos used?

Archegos was betting the stock price would go up via buying complex derivative products called Total Return Swaps (TRS) or Certifications For Difference (CFD). The way these products work is instead of buying a stock outright, 2 parties (in this case Archegos and a corresponding bank) enter into an agreement that is similar to a ‘side bet’ that you place at a casino. The agreement states Archegos has to pay a smaller pre-fixed fee plus borrowing cost at regular intervals while the corresponding bank would in turn pay Archegos if the stock had gains and if there dividends paid. Naturally if the stock dropped in price (like it did with Viacom) Archegos would need to pay up more cash to cover the difference (called a margin call). So buying such an instrument will offer you the benefit of owning a stock without physically buying the stock. Coupled with borrowed money like Archegos did then they could buy 10 times worth of stock (even though they did not directly own the stock). 

Then why would the banks allow Archegos to borrow that much money and amass such a large sized stock position so easily?

Well this is the tough billion dollar question.

To be fair, Bill Hwang, the korean born hedge fund founder of Archegos comes with a pretty strong pedigree. He is one of the proteges of legendary hedge fund manager and billionaire Julian Robertson who’s Tiger Management hedge fund was at one point the 2nd largest hedge fund in the world in the late 90s. Many of Mr. Robertson’s proteges (called ‘Tiger cubs’) now manage many of the top global hedge funds and Mr. Hwang was seen as one of his most successful ones.

But there were also red flags with Mr. Hwang and Archegos that the banks should have noticed and should as a result be much more strict when dealing with Archegos (or reject their business outright). For example in 2012 (when Archegos was still known as Tiger Asia Management) they reached a settlement for insider trading. In 2013 Mr. Hwang and his senior officer at Tiger Asia Management were banned for 4 years from trading in Hong Kong’s stock market due also to insider trading. In 2013 Mr. Hwang converted Tiger Asia Management to become Archegos Capital Management.  

Yet whether it was greed or fear of missing out (FOMO) driven, a large number of banks ended us lending large amounts of capital to Mr. Hwang and Archegos along with allowing them to build up very large but concentrated stock holdings. In hindsight from a risk perspective a number of these banks probably shouldn’t be taking on this much risk.

How did no one pick up on this earlier?

Archegos flew under the regulator’s radar because it operated and invested in a way that meant it did not need to disclose or face much regulatory scrutiny since:

1) Archegos operated as a family office so there was little to no regulation: Family offices are investment companies that are established by wealthy families to advise and manage their own money but in turn are not regulated by the US’ financial industry regulator the Securities and Exchange Commission (SEC). After the Global Financial Crisis of 2007-2009, to increase protection for the financial industry, the Dodd-Frank Act of 2010 was established to increase regulation even for smaller hedge funds or private fund advisors to disclose periodically their investment holdings, banking relationships and other operational details. The one area of exemption from regulation were family offices so that was a major reason why regulators had little transparency of the stocks held in Archego’s portfolio despite them owning huge positions in Viacom, Discovery and many US-listed Chinese stocks.

When looking deeper, according to this Forbes report, family offices in the US are required to report stock and derivative (more complex investment products) investment positions if they are above US$100 million (~HK$777.6 million) to the SEC but derivative products such as swaps (which the ones Archegos used) are excluded.

2) Archegos never ‘owned’ their stock positions outright: So this made it even harder for regulators or banks to figure out how much exactly Archegos ‘owned’ in total.

How is that possible?

Unlike a traditional investment approach where you buy a stock and you are clearly the outright owner of that stock, Archegos instead purchased more complex investment instruments (as mentioned above) called Total Return Swaps (TRS) or Certifications For Difference (CFD). These instruments allowed Archegos to 1) put up very little money up front (thereby increasing their overall investment size) since the banks were very willing to lend them money in this low interest rate environment and 2) buying such complex investment products meant that the stock in question (like Viacom or Discovery) was actually ‘owned’ on the books by the bank they were transacting with and not with Archegos. To make matters more complicated Archegos owned similar and high leveraged positions with at least 8 separate banks which meant many of these banks were not immediately aware the collective holdings of Archegos was that dangerously concentrated.  

By the time many of these banks figured things out a number of them were already on the hook for massive losses. Ouch.

Why does this concern you as an investor?

Because this sudden forced selloff in large sized company stocks like Viacom, Baidu and others increased broad market volatility significantly the past 2 weeks. As you can see below the stock price from names that Archegos’ portfolio held dropped as much as 61.04% in the 8 trading days after:

Plus more importantly, even though you may have never heard of Archegos Capital Management, as an investor you should be aware of the potential risk because:

1) This may not be a one-off situation: We think investors should sensibly be aware there may be more hedge funds or other financial entities who are taking on too much risk and maybe at similar blowup risk. In this current investment environment where borrowing costs are close to zero and central banks are ‘artificially’ supporting markets by pumping in large amounts of money and buying up assets it is not unreasonable to think there may be more players who are similarly taking on excess risk as a result. If financial markets get stressed further we may see more Archegos-like incidents.

2) There may be more ‘forced’ selling coming in the immediate future: The bank driven wave of forced selling has essentially subsided this past week. In the immediate term what we will see are US regulators stepping in to ask some tough questions why such an oversight happened. Beyond pressure from regulators almost every bank’s banking division with or without exposure to Archegos will be probed internally to assess if there are similar risk exposures. The combination or regulators plus internal assessments will lead to risk controls and margin requirements being tightened in response which may force other hedge funds or similar entities to sell part of their holdings to meet these new requirements. From a hedge fund’s perspective, after seeing the aftermath of Archegos, it is also likely they may reduce their risk and add to the selling pressure in the market.

Although in the past week there is a lot of talk in the financial industry that Archegos is an ‘isolated incident’ but considering we’re only 4 months into 2021 and we’ve dodged 2 potential blowups (the Gamestop mania back in February was the other one) that could have sizable negative impact to broad markets further underpins why we suggest investors need to focus on managing their portfolio risk in 2021.

This is not the biggest hedge fund blowup especially from excess leverage

 For those of us experienced enough in the finance industry chances are we still remember the hedge fund cautionary tale that shook up the investment world in 1995 called Long Term Capital Management (LTCM). Based in Greenwich Connecticut in the US and founded in 1994, LTCM was the darling of the financial industry in the mid 90s by returning over 35% per year using a combination of bond arbitrage and high amounts of leverage. Managing over US$1 billion (~HK$7.8 billion) of investor money and ultimately with US$1.25 trillion (~HK$9.7 trillion) in investment exposure it is about 10-20 times greater in risk exposure relative to Archegos. At its peak holding investment positions totalling 5% of the entire global bond market. For 1 single firm to own that much of a market share is almost unheard of. 

Their founder John Meriweather also was a former rock star on Wall Street heading up the bond arbitrage desk at Salomon Brothers (now part of Citigroup) and at one point his trading division alone was reportedly responsible for 80-100% of the global earnings of the entire company from the mid 80s to early 90s.

Even with such an impressive background LTCM eventually met its demise in 1998 with the Russian financial crisis. They held large sized investment positions in Russian government bonds and was hurt badly when the Russian government started to default on its debt (meaning they stopped paying interest on a bond or didn’t honor paying back the principal upon maturity of the bond). This was a big surprise since it was unfathomable a country would default on its government debt when it could print more money as a short term offset. During this period even though LTCM was losing millions of US dollars per day their computer models suggested they continue holding on to these bonds which ultimately was a poor decision.

When the losses started to pile and approach US$4 billion (~HK$31.1 billion) and LTCM having deep business ties with every major bank of Wall Street the US federal government stepped in since it saw LTCM’s imminent collapse as a major threat to the stability of the entire US financial system. Lining up a consortium of the biggest banks including Barclays, Chase Manhattan Bank (now part of JP Morgan), Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Salomon Smith Barney (now part of Citigroup), UBS and more a US$3.7 billion (~HK28.9 billion) loan fund was created in 1998 which allowed LTCM to liquidate its investments in an orderly fashion instead of imploding and causing widespread panic in the financial industry.

So what can investors learn from this blowup?

1) Be careful with leverage risk: In this current investment environment where the cost to borrow money is cheap it is not uncommon for people to take on excess leverage risk like Archegos. We are seeing similar behavior amongst Hong Kong investors who are borrowing more in their stock accounts in order to land allocations for stocks that are IPO-ing or listing for the first time on the stock exchange. Although many times we only see the upside as an investor but understanding the downside is equally important. At 5 times leverage, meaning for every $100 you have you get $500 on borrowed money to invest, a simple 20% loss in the stock would shrink your initial investment to $0 ($500 x -20% = -$100). Meaning a total loss. We aren’t saying investors shouldn’t borrow money to invest but understanding its potential risk is the key for any smart investor. 

2) Diversification is important: In the case of Archegos they concentrated the majority of their portfolio mainly in 8 stocks which meant when 1 stock (like Viacom) had issues their entire portfolio suffered huge losses as a result. Unless you have a crystal ball, we remind many of our investors, particularly in the current investment environment, to diversify their investments more. This is a reasonable way to control your investment portfolio’s downside risk.

In case you were wondering, AQUMON’s investment portfolios do not employ leverage and we scientifically recommend diversified portfolios for our client’s medium to longer term investment needs.

If you have any questions, please don’t hesitate to reach out to us at AQUMON. We’re always happy to help. Thank you again for your continued support for AQUMON. Stay safe outside and happy investing!

Ken

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