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Assessing leverage risks

Updated: Feb 14, 2023

In March, Archegos Capital Management, a family office based in the United States, defaulted on margin calls from several investment banks, including Nomura (which is unfortunately one of the Fund’s biggest long holdings).

The problem with Archegos was simple: too much leverage given the fund’s risk exposure.

The maximum level of leverage depends on a range of risk factors including net market exposure, stock specific risk, position size relative to liquidity, net country exposure, net sector exposures and crowding risk.

These risk factors are familiar to all good quant factor investors. The only one which is difficult to quantify is crowding risk. This resulted in the Great Quant Unwind in August 2007, an event I remember well and which I was able to successfully navigate. Many quant managers had high leverage which was facilitated by prime brokers. The quant funds generally had low exposure to risk factors - except crowding risk. Their models were essentially selecting the same stocks and when quant funds were forced to deleverage at the same time, there were huge liquidity driven price distortions. I have devoted a chapter of my book to this event, including its cause and its ramifications.

The OQ Asia Absolute Alpha Fund does not have high leverage. Gross exposure at the end of March 2021 was below 250%. Net exposures to quantifiable risk factors, including those mentioned above, are low.

Currently, crowding risk is also extremely low. Quant factor investing is out-of-favour following a couple of years of lackluster performance. The most crowded stock positions are currently in the technology sector. Numerous technology stocks have surged over the last 12 months and success begets success. Investors tend to favour outperforming funds, allocating more money to these funds who then increase their holdings further. To illustrate: Cathy Woods’ ARK Investment Management increased AUM more than tenfold in 2020, from $US3.1 billion to $US34.5 billion. Many technology investors also haven’t experienced the dot-com bubble in the late 1990s and the subsequent tech wreck, exacerbating the crowding risk in technology stocks.

As a side issue, I believe that fund allocators would be better served if they didn’t follow the crowd and focused more on funds’ future outlook based on the current market environment rather than outperformance over the last couple of years, but often the reputational risks associated with allocating to an underperforming investment style are too great to overcome.

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