Hedge Fund Tilt and Market Volatility

Forget about smart money.

It does not exist anymore. And if it does, it isn’t hedge funds who are twisting in the wind everywhere…

A couple of  broad statistics:

In 2011, the average hedge fund dropped 4.8% while the $SPX closed flat on the year.

In 2012, through May, hedge funds are up .88% while the $SPX has been higher by 4.2%.

So there’s 1.7 Trillion $ being put to work attempting to generate positive uncorrelated returns and failing.

Managers charging considerable fees who also have their own capital and reputations tied up are under incredible pressure to perform and they are not.

Meanwhile, nothing fosters irrational investor behavior more than losses.

Loss aversion is a funny thing too, highly subjective and dependent upon the situation. A manager might be net positive on the year yet underperforming a benchmark alters his reference point or the level at which he perceives he is breaking even.

There’s a reflexive aspect to it, managers are underperforming, experience loss aversion (or tilt) and respond with market behaviors that are irrational including holding or pressing losers, chasing popular stocks, overtrading, selling winners too soon, veering away from discipline and risk management strategies etc.

Such irrational (and costly) behaviors across multiple managers and substantial AUM in turn affect the behavior of assets, increasing volatility, choppiness, erratic movements etc.

This in turn puts more pressure on the managers

A nasty cycle…

Collectively, hedge fund manager tilt is adding to the apparent choppiness and seemingly erratic behavior of broad indices as well as individual names.

Its not the only factor. For sure, HFT and an incredibly tenuous and complicated global macro environment play a roll – but they are talked about daily while hedge fund tilt is not.