Managers feel the derivatives pinch

european long/short equity

"There was a really big derivatives component in this correction which we haven't seen before," says Peter Schell, head of research at Park Place Capital, most significantly variance swaps, used by many managers to trade volatility, in May's painful crunch.

Banks selling them must hedge positions with strangles, he notes. "When the market moves too much, the banks have to sell gamma," he says. When the market fell significantly, it collapsed at 4 o'clock, he says. "It's like 1987. It's portfolio insurance gone funny."

"Quite a lot of May's decline was people selling index futures to give them a hedge on the downside," agrees Markus Rezny, fund manager at Griffin Capital Management. Variance swaps and credit default swaps, he agrees, were an important factor defining the market recently.

"There are new derivatives being used, the first time the market has corrected with these kinds of contracts," he adds. "It's given it a new characteristic, which at this point nobody understands." Whether the proliferation of these products adds significant risk to the system, with this being a warning sign, remains to be seen, he says. Schell says the future is uncertain. "We're right below an important resistance level, and right above an upward trend. It's difficult to think about it fundamentally because right now the market is totally schizophrenic," Schell says. "Bad economic numbers are actually good for the equity markets because it means rates aren't going to go up."

Hugues Le Maire, fund manager of Rothschild's European long/short Blackpoint fund of hedge funds, says 36 months of an almost uninterrupted bull market has created overvaluation and encouraged most managers to run long-biased portfolios, many gross long in excess of 100%. There has been little shorting, except of indices, understandable as shorts have been costly to execute, difficult to find and unprofitable, he adds.

"There's a new guy (Ben Bernanke) at the Fed, so people listen more carefully and they think he's saying misleading things," notes Rezny. "When there's a new Fed governor, everyone always gets very uptight, and they say he has to learn how to talk to the markets."

Markets have been moving according to macro factors, not micro factors. Le Maire notes first quarter data had been priced in before the correction and second quarter data had not yet arrived. However, he sees the first signs of a return to stock-specific trading that will create more opportunities for long/short managers, especially on the short side. He expects more stock-specific shorts, as opposed to index shorts, in the forthcoming, more discriminating market.

"There is a slightly inverted yield curve in the US which, strangely, no-one seems to be talking about," says Schell. "That generally means a significant economic slow-down. So we're having a tough time being enthusiastic about growth-sensitive stocks. We'd prefer to short them on any strength," despite almost uniform optimism among companies.

Norway has been the region's worst performer with its heavy exposure to the commodity sector, Rezny says, while most other markets have behaved similarly.

Park Place has made money in Norway on the short side, for example in SeaDrill, though it has also made some losses on its longs there. Particularly badly hit, he notes, were any companies associated with metals.

Only some stocks with strong defensive qualities proved exceptions. Nutreco, a Dutch company that makes animal feed, was very steady throughout the period, he notes. A cash-rich company, there was widespread belief it would return cash to investors or use it for wise acquisitions.

Park Place approached May de-levered from 2.5 to 1.5, without changing its moderate short exposure in expectation of a market correction, but was surprised by the extremity of the move. Its short position, which it still holds, is tactical rather than strategic, Schell notes. It still lost 40bps in June.

Griffin is also adopting a defensive position, scaling down its overall exposure, though it does not use leverage even when it has high conviction.

"Compared to other corrections, the market has not recovered. In the old days, you got a short sharp correction with lots of damage, a brief bottom and a significant bounce," says Schell. In this instance, a small bounce was followed by a second fall.

Rezny disagrees: "I have the charts in front of me now and they are V-shaped," he says, though "it is understandable that people feel bearish." Griffin is currently running a moderate net long position.

Le Maire comes out on the side of Schell, believing June performance overall to be flat or slightly down. He says the volatility outlook has improved, while a higher level of dispersion will benefit long/short managers generating alpha. Liquidity considerations are less favourable, though not a cause for major concern.

He says two months of market panic have not yet translated into significant redemptions because year-to-date performance has remained positive. Confidence will melt away if losses turn YTD returns negative, he says, though managers should find upcoming market conditions more suited to generating returns. He is confident in his investments, with Blackpoint running a concentrated portfolio of 16 managers, all with experience in bear markets.

KEY POINTS

Variance swaps, used to hedge volatility, are among the derivatives that managers believe contributed to the market corrections they witnessed in May.

Norway was Europe's worst-performing region in May, largely due to that country's exposure to commodities.

Managers were surprised by the severity of May's falls, but many have not yet seen any significant redemptions.

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