While markets continue to grind higher and notch new highs, there have been a few blips along the way. The first stemmed from Melvin Capital and GameStop, and just recently, Archegos Capital was a forced seller of ~$20 billion of securities.

While these were separate, isolated incidents, their commonality was the involvement of hedge funds. Melvin Capital and Archegos aren’t exactly small players. Combined, they managed ~$22 billion of assets before factoring in leverage (more on that below).

To provide context, the hedge fund industry manages ~$2.9 trillion, with Bridgewater being the largest at ~$138 billion.

The goal of most hedge funds is to maximize returns while attempting to minimize risk using various trading instruments and strategies. The key word is “attempting,” as things don’t always go as planned. Thankfully, both incidents appear to be contained, but the events have left many wondering whether they are a harbinger of what’s to come and the catalyst for future market sell-offs.

The purpose of this commentary is not to disparage hedge funds but rather to understand their impact on markets and volatility, given their size and power.

Leverage and Derivatives

Both leverage and derivatives are two important aspects to hedge funds. With massive size comes massive power. During the 2007 financial crisis, both were viewed as culprits for the collapse of the housing market.

In short, leverage allows for the purchase of additional securities on “margin” (aka borrowed money) in an attempt to juice returns. When factoring in leverage, hedge fund assets increase from $2.9 trillion to $6.3 trillion! The use of derivatives allows for increased levels of leverage.

While individuals can employ leverage, their impact on markets is negligible. That’s not the case with hedge funds as a report from the U.S. Securities and Exchange Commission (SEC) indicates that ~30% of the derivative exposure was held by the 10 largest hedge funds.

Most mutual funds and exchange-traded funds (ETFs) employ little to no leverage as they face higher regulatory scrutiny. An investor purchasing a fund pegged to the S&P 500 index can expect to earn the market-cap-weighted returns of the 500 largest U.S. publicly traded companies.

Pretty straightforward.

On the flip side, hedge funds attempt to outperform their respective benchmark, net of fees. To do so, many employ leverage and complex derivative strategies, which can backfire if not used appropriately or when markets experience unexpected volatility.

The issue is that hedge funds are not required to disclose all their holdings, making it difficult to assess the underlying risks.

This is essentially what happened with Archegos. While the fund was managing ~$10 billion of assets, the positions reached ~$50 billion using leverage and complex derivatives. Unfortunately, Archegos made a few bad investments, which led to margin calls that forced them to dump over $20 billion into the open market.

Discovery and ViacomCBS were the hardest hit and plummeted over 45% in days!

While Archegos Capital manages personal family wealth and no public money, it spooked markets and wreaked havoc on investors who held these stocks.

Now, to be fair, some of the best-performing long-term investments are hedge funds. A majority don’t experience volatility as we witnessed with Melvin Capital and Archegos. But these incidents illustrate the unpredictable nature of the industry.

With that being said, the actions of a few are not a reason to panic or sell, but to understand the volatility that can come from such practices.

History tends to repeat itself unless something is done. This article is not a call for action to end the hedge fund industry, but given their size and influence on markets, a discussion around increased transparency and a more robust system of checks and balances seems warranted.

Repeat incidents could cause investors to lose faith and rattle markets. If Archegos or Melvin Capital happened to one of the larger hedge funds, the fallout would be massive and would surely send markets into a frenzy.

The good news? The Financial Stability Oversight Council seems to be listening.

Discuss your situation with a fee-only financial advisor.

The commentary on this website reflects the personal opinions, viewpoints and analyses of the Divergent Planning, LLC employees providing such comments, and should not be regarded as a description of advisory services provided by Divergent Planning, LLC or performance returns of any Divergent Planning, LLC Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Divergent Planning, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

Divergent Planning, LLC provides links for your convenience to websites produced by other providers or industry related material. Accessing websites through links directs you away from our website. Divergent Planning, LLC is not responsible for errors or omissions in the material on third party websites, and does not necessarily approve of or endorse the information provided. Users who gain access to third party websites may be subject to the copyright and other restrictions on use imposed by those providers and assume responsibility and risk from use of those websites.

Divergent Planning, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Divergent Planning, LLC and its representatives are properly licensed or exempt from licensure. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Divergent Planning, LLC unless a client service agreement is in place.

General Notice to Users: While we appreciate your comments and feedback, please be aware that any form of testimony from current or past clients about their experience with our firm on our website or social media platforms is strictly forbidden under current securities laws.