Fear Maybe The Catalyst To Send The Stock Market Higher!
Hedge Fund Managers and Window-Dressing!
by Ian Harvey
October 01, 2012
September has dispelled the theory that “it is a bad time to be in the market!” Despite a negative showing for the week, the major equity indexes wrapped up the month -- and the third quarter -- solidly higher. As we head into the fourth quarter of 2012, many hedge fund managers are behind the eight-ball, as this group has remained stubbornly underexposed to equities throughout the recent uptrend.
‘Hedge Fund’ refers to an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).
Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.
For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.
Therefore, a ‘Hedge Fund Manager’ is an individual who oversees and makes decisions about the investments in a hedge fund. Managing a hedge fund can be an attractive career option because of its potential to be extremely lucrative. To be successful, a hedge fund manager must consider how to have a competitive advantage, a clearly defined investment strategy, adequate capitalization, a marketing and sales plan and a risk management strategy.
Individuals wishing to invest in hedge funds must meet income and net worth requirements. Hedge funds can be considered high risk because they pursue aggressive investment strategies and are less regulated than many other types of investments. The hedge fund manager is responsible for the investment decisions and the operations of the fund.
A few of the equity indexes are stuck below historically significant resistance levels, but there appears to be more than enough short-covering potential to help stocks take out these looming barriers.
Hedge Fund Managers Have Some Catching Up to Do
“…..The following may be catalysts for the VIX to lift back into the 17-18 area:.....One sign that points to a potential upset in the market (from a sentiment perspective) is growing optimism among investment managers, according to the most recent National Association of Active Investment Managers (NAAIM) survey. Another is the growing optimism among equity option buyers, who are now buying two calls for every put…..”
1. September expiration is behind us, including VIX options that expired Wednesday last week. The implication is that hedged positions that have expired could be replaced, as index protection is perceived as cheap by many market watchers.
2. There is still an extremely cautious mentality among traders and investors -- witness the record call open interest on VIX options just before September options expired on Wednesday.
3. The VIX is trading 50% below its calendar-year high, a level that was supportive last month at this point in the expiration cycle.
4. Earnings season is around the corner, and elections are just down the street.
- The VIX Ready to Move Higher!, September 26, 2012
"…..Bond and money market assets at Boston-based Fidelity now total $848.9 billion, more than half of the company's $1.6 trillion in managed assets. Ford O'Neil, a top bond manager at Fidelity, underscored the milestone on Wednesday during a media presentation in Boston... The rise of bond and money market funds, including institutional assets, is a remarkable turn of events for Fidelity. The company built an empire in the 1980s and 1990s on stock funds and star stockpickers like Peter Lynch. Fidelity's stock mutual funds held $761 billion at the end of June."
- Reuters, September 26, 2012
The CBOE Market Volatility Index (VIX - 15.73) indeed popped last week. In fact, its high of 17.08 on Wednesday was 22% above the previous Friday's close. The advance was not a major shock, as the VIX entered the week trading at the prior month's low and 50% below its calendar-year high. In addition, the spread between Standard & Poor's 500 Index (SPX - 1,440.67) historical volatility and the VIX had narrowed, leaving room for a VIX advance.
With continuing uncertainty related to the ”fiscal cliff” and the "Three Catalytic E's" -- Earnings, Elections, and Europe -- call open interest on the VIX grew by 520,000 contracts last week, while put open interest rose by only 225,000 contracts. It appears that extreme caution continues to be the flavor of the day among some hedge fund managers, and their protective -- or speculative -- bets against the market tend to cap rally attempts. Such behavior sets up the "unwinds" that eventually push equity indexes through resistance levels, and we could continue to see this pattern in the fourth quarter.
Equities pulled back amid the VIX jump, with small-cap and mid-cap stocks failing at longer-term resistance areas. For example, the Russell 2000 Index (RUT - 837.45) attempted to take out the 865 area, which marked major tops in 2007 and 2011. The index ventured into this territory during September expiration week, but was turned away in last week's trading. A potential support area for this index is 830, which had served as resistance on a weekly closing basis before the breakout in early September. If 830 fails, the RUT could decline to the 800 century mark, which is the site of a trendline drawn through higher lows since October 2011. If the 865 area is taken out to the upside, the round 900 century mark would be the next speed bump, as it's approximately 50% above the RUT's September 2011 low.
Meanwhile, the S&P MidCap 400 (MID - 989.02) ended September back below the 1,000 millennium mark, after moving into all-time high territory earlier in the month. But the MID's low last week was at its 40-day moving average, and this trendline has alternately served as both support and resistance on several occasions this year.
For market bulls, it could be encouraging that the MID held above its 40-day average, since this trendline might now serve as a springboard for a more sustained move above the 1,000 area. Moreover, the MID rallied from Wednesday's low to close in the 990 area, which previously marked resistance back in February.
Last week, the conclusion was that the market was vulnerable to a decline, as equity option buyers and active investment managers had grown optimistic about the short term. But as noted, the declines were likely to be shallow, given a huge short position in the market that represents potential support if those bears look to bail on their losing bets.
It was quite interesting that these short positions on SPX component stocks actually grew in the latest reporting period, per the chart below. We suspect this activity is driven by hedge funds, which remain underexposed to equities. In fact, as of mid-September, it was reported that 92% of fund managers were trailing the SPX year-to-date, with the average hedge fund up only 6.7%.
The fourth quarter is now upon us, implying hedge fund managers are running out of time to post impressive calendar-year results. Therefore, similar to the situation we had around this time last year, it's quite possible that short-covering activity could occur, as deep-pocketed hedge fund managers make a collective effort to boost their overall equity exposure. In other words, it could be fear that drives the stock market higher -- fear of missing yet another rally!
Other Important Articles Relating to the Week Ahead
1. The Economy and Earnings in the Week Ahead – October 01, 2012
2. The Past Week Stock Market Results – October 01, 2012
3. The Week Ahead in the Stock Market – October 01, 2012
4. The Major ETFs in the Week Ahead – October 01, 2012
5. The Dow Theory and Transport – October 01, 2012