Correlations

Today I read two pieces on a topic that has been on my mind lately, especially after reading "When Genius Failed", a book about Long Term Capital Management.  How correlated are hedge-funds and proprietary trading arms of investment banks?

The first piece is a Bloomberg article (via Paul Kedrosky).  Paul has highlighted the eye opening section:

They’re all backing the same trades, behaving like index-
tracking mutual funds. Instead of convincing investors that the
only way to make 50 percent in a year is to be willing to lose 20
percent in a quarter, they eke out profits by retiring winning
trades almost as soon as they are in the black. Instead of
scouring the globe for unidentified gems, they spend their time
bandwagon-hopping.         
      

"The correlation of hedge-fund returns is very worrying,”
said Donald Sussman, chairman and founder of Greenwich,
Connecticut-based Paloma Partners Management Co., who spoke at a
panel discussion in a tent at the festival. "Everyone does well
in a bull market, and badly in a bear market."

Not exactly surprising.  I have previously wondered about the sustainability (and validity) of high returns in the hedge fund field, but the level of correlation poses an additional concern.

The second piece is a blog post by Steve Richmond, my close friend and former business partner.  He’s looking at the trading profits at investment banks:

…the Ibanks have placed themselves at the nexus of information and
human capital.  I have no doubt, that within a fairly limited spectrum,
they do recruit a higher percentage of the "best and brightest" than
most industries.  But they also have their "ears to the ground" like no
other organization — they understand they can make high quality trades
with great information, and they have modeled their businesses to
attract this information.

They see everyone’s trades.  They get leads from their hedge fund
clients, private equity clients.  I would guess a good deal of
information drifts across the Chinese Wall from their M&A group.
(Even though they would be loath to admit it.)  They have high level
contacts in governments where they do privatizations and other floats.
They have research analysts scouring the "channel" and piecing together
investment theses.  They have proprietary data models that help them
see opportunities.  They are truly at an "information delta" and  use
their proprietary trading desks to farm the soil.

Then, he goes on to pose what I think is the critical question:

Secondly, if competitive pressures within the industry are so strong,
are they being forced to put increasingly larger portions of their
balance sheets at risk, and therefore increasingly vulnerable to a
melt-down that could drastically effect the global economy?  It would
be interested to know how correlated Wall Street’s proprietary trading
desks are.   My bet is that they are more correlated than most would
care to admit.

Seeing the signs of shrinking liquidity in the global markets, with emerging markets leading the field, and knowing that much of the aforementioned trading profits in those emerging markets, this potential for a high level of correlation in institutional trading is scary.  All you’d need is a few negative factors aligning and you’d get one enormous meltdown.

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