28 September 2011 at 9:15 GMT
A dangerous cocktail is brewing
Classical long-only stock mutual funds in the U.S. have lowered their cash balances in aggregate to the lowest levels since 1986 according to figures from ICI Mutual Fund Statistics. If you combine this fact with increasing risk adversity among retail and institutional investors in addition to high correlation among many assets classes then the financial system may have a new time bomb ticking, ready to explode in what could be a perfect storm.
However, a bomb always needs a trigger mechanism and in this case the trigger is asset redemption, the worst nightmare for any portfolio manager. With Man Group's, one of the world's largest hedge funds, shocking announcement today concerning huge asset redemption the trigger may already have been set in motion in the highly leveraged hedge fund industry.
Man Group plunges 18% on $6 billion redemption
The London listed hedge fund manager with USD 71 billion under management at the end of June announced this morning shocking news that investors have redeemed USD 6 billion, or 8.5 percent of total assets, driven by what Man Group calls suppressed demand for alternative investment products. Investors have reacted promptly by sending the shares down 18 percent in early morning trading (see chart below).
Source: Bloomberg
Man Group's CEO Peter Clarke adds a very critical comment in that management expects investor demand to remain depressed for the remainder of the year as poor performance and high volatility are the culprits. The comment indirectly opens the door for more asset redemption going forward and this is what could trigger the perfect storm. The important point is: if so-called sophisticated hedge fund investors are nervously asking for redemption then what is the purpose of ordinary retail investors having their bulk savings in only long mutual funds?
Low mutual fund cash leads to higher sensitivity
As Nassim Taleb, author of the Black Swan, talks about all the time systems with very high sensitivity to unexpected events are the most dangerous. This characteristic fits very well to the present situation with U.S. stock mutual funds sitting on only 3.3 percent in cash relative to overall assets invested (down from around 10 percent in the late 80s). The underlying problem in financial markets is that correlation between individual stocks, sectors, asset classes etc. is record high thus reducing the benefits from diversification leading to higher volatility and poorer performance - a beautiful trigger for retail investor redemption.
Hugh asset redemption ahead?
If retail and institutional investors are getting overly risk adverse then we could easily see huge asset redemption; Man Group's announcement today shows it may already be underway. In fact retail investors have also redeemed assets as net cash flow in U.S. stock mutual funds have been negative for the last couple of months. What happened last time we had low cash levels and unexpected asset redemption?
Déjà vu
Back in June 2007 cash levels were also standing at around 3.5 percent and suddenly we had bank runs in the U.K. and meltdowns of credit hedge funds in the U.S. which slowly evolved into the financial crisis of 2008. The meltdown in stocks was amplified by large negative net cash flow in U.S. stocks mutual funds which forced low cash mutual funds to offload stocks in order to return money to their investors; the same pattern occurred in the hedge fund industry which leverage amplified in that part of the money management industry.
With cash balances at 3.3 percent, volatility on the rise, poor performance, redemption at Man Group and policymakers adding to uncertainty could events seen in 2008 happen again? Indeed they could as all the factors are in place. If asset redemption was to explode unexpectedly then it could very well trigger a plunge in stocks.