How One Hedge Fund Got Wrecked in a Hurry

How multi-directional volatility -- and human nature -- undid the Spruce Alpha hedge fund

Oct 2, 2015 at 9:09 AM
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Well, we officially have our first high-profile wrecked hedge fund story of the 2015 correction (or bear market ... we'll see). Via The New York Times:

"It was an upstart hedge fund that pitched large returns in periods of market turbulence by relying on a complex and controversial trading strategy.

"At the height of the 2008 financial crisis, investors would have had a gain of more than 600 percent, according to projections in investor documents for the new hedge fund, Spruce Alpha.

"But when markets again turned volatile this August, Spruce Alpha, which had started in April 2014, failed to turn the turmoil to its advantage. For that month -- a particularly difficult period for many money managers -- Spruce Alpha fared worse than most, losing investors 48 percent of their money, according to documents reviewed by The New York Times."

What was the controversial strategy? They don't say. But there are a couple of clues.

For one, they refer to exchange-traded funds (ETFs), and the seizing up thereof on Aug. 24. For another, they refer to leverage and the fact that said ETFs are really only designed for one-day performance. So, I'm going to put two and two together and say the strategy played with leveraged ETFs.

Which leveraged ETFs? Well, the person briefed on the Spruce Alpha fund said the August losses were the result of unprecedented upheaval in the CBOE Volatility (VIX), an index that measures volatility in the market.

Ok, then. Sounds like we're talking about the VelocityShares Daily 2X VIX Short-Term ETN (TVIX), and/or the ProShares Trust Ultra VIX Short-Term Futures ETF (UVXY), and/or the ProShares Short VIX Short-Term Futures ETF (SVXY).

Even though the VIX didn't make a historic move in terms of points or actual percentages, it did make a historic move as measured by the speed of the move as quantified in percentage terms. So, yes, I can see where someone on the wrong side of it maybe got drilled.

But here's what's a bit of a mystery: How did a fund that billed itself as able to generate large returns in a period of turbulence do the diametric opposite? The alleged culprit isn't the volatility itself, but rather the fact that the volatility was multi-directional.

Let's say they only used UVXY and SVXY. Just to refresh, UVXY is two times the iPath S&P 500 VIX Short-Term Futures ETN (VXX), while SVXY is negative two times VXX. If they missed the start of the market drop, but then loaded up on UVXY at the close of Aug. 24, they would have done perfectly fine. It closed at $57.30 that day. It actually went even higher -- much higher, as it peaked at a closing high of $87.54 on Sept. 1. It then dropped, of course, but closed yesterday at $54.78, so it's a round-trip to nowhere so far.

They could have instead faded the move and bought SVXY on Aug. 24. That runs exactly counter to their stated objective of profiting/protecting during times of market turbulence. But, hey, what's a little "style drift" between friends and family?

Well, that side didn't do quite as well. But it's also not an absolute disaster. SVXY closed at $57.14 on Aug. 24, drifted as low as $41.63, and closed last Friday at $49.09. However, it's hard to believe they bought and held SVXY, since I'd like to think a fund is sophisticated enough to know not to buy and hold a leveraged tracker ETF.

There are indeed funds that short both sides of leveraged ETF "pairs" and try to play the compounding-attrition game. It's a de facto short gamma trade, and like a short gamma trade, it mostly works -- until it doesn't, in a big way.  

Again, they mention that what did Spruce Alpha in was the gyrations, not the one-directional move. That's exactly the opposite of what you'd see if you shorted both.

All I can guess is they flipped these pups with incredibly bad timing. And then, as losses mounted, they increased size to try to make it back -- and thereby compounded the losses. Frankly, not enough happened here, or in the market in general, to explain the asset implosion.  

And if that's the case -- well, you can blame leverage and ETFs, since that's what they presumably used as a trading vehicle. But it's more likely hubris and human nature, and someone doubling down a bad bet with someone else's money. The marketing based on outsized, back-tested returns is inherently dishonest. It's not tough to data-mine a strategy that worked in reverse. I'm guessing the leaked cause of the demise here is a bit misrepresented, as well.  

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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