Hedge Fund Liquidity Plunges To "Danger Zone" For US Stocks

Simply put, the massively overcrowded hedge fund herding into US equities has created a crisis situation. With liquidity levels at record lows, the market will be unable to smoothly absorb any concerted selling pressure from large money managers.

“When hedge funds get spooked about something and they all delever, there are going to be small pockets that get disproportionately hurt,” Altshuller said.


“Certain stocks are down 20, 40 percent with no apparent reason. Others catch the fear bug and start selling.”

There's safety in numbers, Bloomberg's Lu Wang notes, until a stampede starts. That’s the theory underlying a study of hedge fund holdings by Novus Partners Inc., which sought to calculate how easily the market could absorb concerted selling by large money managers. Using an analysis that turns mainly on how much volume is occurring in stocks favored by professional speculators, Novus says liquidity is at an all-time low.

“Their ability to sell in the marketplace is really going to depend on their peers who are trying to sell at the same time,” Stan Altshuller, chief research officer at the analytics firm, said by phone. “It becomes the prisoner’s dilemma.”

Bloomberg's Wang reports that Novus began with the premise that most hedge fund managers have an idea of how a stock would react if they alone started bailing. It then tried to estimate a broader impact: what if everyone bailed at the same time?

Looking at equity funds with $2 trillion and limiting daily divestitures to 20 percent of a stock’s average volume, Novus calculated that the market could absorb only about 13 percent of the industry’s total holdings in a month right now. The measure, dubbed 30-day liquidity, has averaged 32 percent since it began tracking the data in 1999.


In a market where volatility has all but disappeared and the S&P 500 Index trades at all-time highs, the study suggests a hidden risk lurks should sentiment suddenly sour. A similar deficit of liquidity exacerbated selloffs in the past 18 months as stocks beloved by hedge fund managers led the plunge.


As money flocks to popular names, the window of escape gets smaller. Novus, which sells products aimed at avoiding liquidity traps and managing risks, theorizes that it’s no coincidence that in each of the last three years, the low point of liquidity all came within three months of a market selloff. Last time it was as low as it is now in July 2015, the S&P 500 suffered the worst decline in four years the next month.


In addition, the last bear market started in October 2007, just four months after liquidity appeared to be drained out from hedge funds.

This lack of liquidity builds on our growing fears in US equity markets as highlighted by the discussion of "Catalyst Fund"'s impact on markets last week...

So it is possible to understand why the fund may suddenly have done so poorly, but could it really have driven the market?

$3.5 billion seems too small at first to drive the entire market (and the manager has been quoted to saying it wasn't responsible for market moves), but it did act leveraged - with returns of more than 5 times that of the S&P 500 - so it may have acted more like a $20 billion fund - large, but still hopefully too small to drive the market.


In all likelihood this particular fund is just a relatively public example of a more widespread strategy - a strategy that was getting hit across the board.  I am more willing to believe the argument that this fund was just one of many funds trading this strategy and that everyone employing this strategy was hit by the same combination of factors and that this widespread unwind was driving the market.


I want to believe that view, because the alternative, that liquidity has devolved to the point that a relatively small and formerly obscure fund can drive the entire market for days on end is quite scary as both a trader and investor.