No Hedge Against the Storm
By TAN Kee Wee
(MediaCorp 938LIVE’s Money Talks, Thursday, 23 August
2007, 7.45 am and 7.20 pm)
These days, when we leave the house, we carry an
umbrella, just in case it rains. What we are doing is hedging
against getting wet. And the cost of our hedge is the effort of
carrying the umbrella.
In the investment world, hedging is quite commonplace.
However, one type of investor makes a living out of hedging
positions all the time. These are the hedge funds.
The basic idea of a hedge fund is to profit when,
simultaneously, a group of stocks fall in price, while another
group of stocks rise in price. Profits from these trades do not
depend on whether the whole market goes up or down. This is why
we use the term “hedge fund”.
In recent years, many of the world’s 8,000 hedge funds
have adopted the very popular “quant strategy”. Here, computer
models buy and sell thousands of stocks, or just about anything
else that can be traded, based on a behaviour that is supposed
to be stable.
Let me give an example. Let’s suppose migrant workers
on an island use telephones to speak to their mainland family
members during the weekdays. During the weekends, they fly over
to the mainland to join their family members. So telephones are
not used during the weekends.
Because of this regular behaviour, airline sales rise
during the weekends, when migrant workers fly, and fall during
weekdays when they don’t fly. On the other hand, telco sales
rise during the weekdays, and fall during the
Let’s now assume that the rise and fall of sales of
both the telcos and airlines are reflected immediately in the
rise and fall in their stock prices.
Just before the weekend begins, the computer program
in a hedge fund would buy airline stocks when they are
undervalued, and sell telco stocks when they are
After the weekend, the same computer program would
reverse this instruction. Such a strategy does not always
guarantee profit. But over time, the winning trades will
produce better-than-average returns.
For a long time, all went well for these hedge funds.
Once in a hundred years, an unexpected storm will emerge and
this quant strategy will fail.
In our illustration, an unexpected tropical storm
struck the island during the weekend. In response, migrant
workers canceled their flights. And they remained on the island
and telephoned their family members.
This unexpected behaviour made airline stocks fall
during the weekend when they should have risen, and made telco
stocks rise when they should have fallen. As a result, the
hedge funds got hit from both sides. As losses mounted, they
responded by selling their shares.
Perhaps, that’s what happened last week in the global
markets. It was the climax of the unexpected storm, which first
started in the subprime markets a few weeks back.
The worst hour was just after Friday lunchtime, when
rampant selling saw prices plunging. The markets behaved like
the man who rushed to the rest room after eating too much spicy
The weakness of this quant strategy has since been
identified, and hedge funds have adjusted their computer
programs accordingly. This means that a repeat of last week’s
market diarrhoea is unlikely to happen in the near future,
especially after the recent US rate cut.
The road ahead may still be cluttered by debris, but a
clear path is emerging. I won’t be surprised if the Straits
Times Index goes back to its recent high before this