How hedge funds cut their risk to gain an edge

Hedge funds are scaling back from high-risk trades after a rollercoaster week in global markets. The market's sharp selloff and subsequent recovery were sparked by the unwinding of massive yen-funded positions and mounting fears of a US recession. The CBOE Volatility Index (VIX) hit its highest close in nearly four years on August 5, signaling increased market uncertainty.

The recent market swings have been especially challenging for hedge funds. Global macro quantitative funds saw losses between 1.5% and 2.5% from August 1 to August 5, while technology-focused hedge funds experienced even steeper declines of 2.5% to 3.5%, according to data from PivotalPath's exposure model.

We’ve observed some deleveraging, which invests in various hedge funds. Portfolio managers are not panicking, but they are trimming positions. When long-term trades unwind abruptly, it impacts risk appetite. We might see investors being more cautious about taking on excessive risk for the remainder of the summer.

Despite the uncertainty, major US indices managed to post gains. The Dow added 1%, the S&P 500 rose nearly 1.7%, and the Nasdaq jumped 2.4%.

Hedge fund leverage has reached its highest level in a decade, according to the Office of Financial Research’s Hedge Fund Monitor. US-registered hedge funds ended March with $2.3 trillion in borrowing from prime brokers, a 63% increase from December 2019, outpacing asset growth.

Last week saw significant unwinding of various positions. Commodity-trading advisors (CTAs) sharply reduced long equity positions and short positions in yen and Japanese assets following weaker-than-expected US jobs data on August 2, as reported by JPMorgan.

A note from Goldman Sachs’ prime brokerage on Friday revealed that long/short equity hedge funds reduced their exposure to Japan from 5.6% to 4.8% last week, while overall portfolio leverage was cut by nearly one percentage point, to 188.2%.

US Commodity Futures Trading Commission data indicated that hedge funds reduced their net short positions on the Japanese yen to the smallest level since February 2023, signaling an unwinding of the yen carry trade.

Concerns about the US economy are now front and center for portfolio managers. Fears of a recession in the US intensified after July’s unemployment rate increased, prompting further de-risking of portfolios. Rulli noted that while macro hedge funds still see potential in the steepening US yield curve, many are locking in profits after a strong performance over the past month.

As of August 12, the CME FedWatch tool shows a near-even split between the likelihood of a 25 or 50 basis point rate cut at the Federal Reserve’s next meeting in September. “When the market is split between two outcomes, it means uncertainty is at its peak,” said Richard Lightburn, Deputy Chief Investment Officer at MKP Capital Management. He is considering portfolio adjustments to navigate this unpredictable environment. “This signals heightened volatility ahead,” he added.

Conclusion

In times of increased volatility, traders need to stay agile. As hedge funds pull back from high-risk positions, opportunities arise for those who can navigate the uncertainty. Focus on diversifying your trades, stay informed on market indicators, and be prepared to adapt your strategies as the landscape shifts. While the market’s direction may be uncertain, a disciplined approach can help you take advantage of the volatility and position yourself for potential gains.