- Implosion of technology and AI-focused US hedge fund provides a reminder of age-old lessons
- Rival Citadel hedge fund has swooped to pick up assets from the distressed seller
- Situational Awareness’ woes may explain why share prices of tech and AI-related stocks have been so volatile
- Bulls will argue sales to Citadel could herald a bottom after recent falls
- Sceptics will assert wider issues regarding liquidity, leverage and concentration risks have yet to be fully addressed
“The stunning fall of the US technology and Artificial Intelligence-focused hedge fund, Situational Awareness, may go some way to explaining why so many shares in these sectors have been so volatile of late, and bulls will be tempted to argue that Citadel’s swoop for the public shareholdings of a distressed seller may help to call the bottom and set the foundations for the next upward move,” says AJ Bell investment director Russ Mould.
“Sceptics will counter that the founder and lead manager of Situational Awareness, Leopold Aschenbrenner, ignored age-old lessons about liquidity, leverage and concentration risk, lessons which many private investors may not be fully heeding either, given widespread use of zero-days-to-expiry options, leveraged exchange-traded funds (often on single stocks) and margin to pile into popular stocks that represent big chunks of headline equity indices.
“Aschenbrenner’s fund was up by more than 400% in the first six months of this year, but it has since suffered major losses on AI-related stocks such as South Korean silicon chip maker SK Hynix, not helped by its use of margin, or borrowed money, to goose returns.
Source: LSEG Refinitiv data
“The plunge in the asset valuation of the fund, which reportedly reached $24 billion at some stage, puts Situational Awareness at, or near to, the top of the list for spectacular falls from grace, even though there is no shortage of examples of what can go wrong when debt or complex trading strategies are deployed to try and gear up profits.
“They include Barings in 1995 ($1 billion loss), LTCM in 1998 ($3.7 billion), Amaranth in 2006 ($6 billion) and Archegos in 2021 (at least $10 billion, with further losses inflicted upon its prime brokers).
“Even supposed ‘hedging strategies,’ designed to dampen market risk have often only served to accentuate it. Examples here include the ‘portfolio insurance’ programmes that contributed to the 1987 Crash, Metallgesellschaft losing its shirt in the oil market in 1992 and AIG’s significant contribution to the Great Financial Crisis of 2007-09.
“In many ways, soaring tech and AI-related shares may have been overdue such an accident. The only question now is whether the damage is limited to the Situational Awareness hedge fund, or whether there is a wider, spill-over effect.
“The good news is that Citadel’s swoop may limit the contagion, while the fall-out from the Barings, LTCM, Amaranth and Archegos episodes proved limited, even if LTCM required a Federal Reserve-coordinated bail-out to soothe roiled markets and Archegos drove another nail into the coffin of the ailing Credit Suisse, which finally fell into the arms of its Swiss rival UBS in 2023.
“The bad news is that such knock-on effects can develop quickly.
“When an investment firm with lots of debt has large positions that are becoming stressed (and in the case of leveraged entities using margin, that can mean even small drops below the initial entry price), that institution may be forced to sell assets in order to meet margin calls and make good on its borrowing, according to the demands of its creditors. Such selling leads the market to drop further, which prompts further loss of value of the collateral, which forces yet more selling – and so on. This also means that asset classes entirely unrelated to the initial problem position(s) can be caught up in the melee – which explains the old market saying about how ‘all correlations go to one’ in a downswing, as distressed sellers just liquidate anything for which they can find a buyer.
“This is why Richard Bookstaber argues in his history of markets and hedge funds A Demon of Our Own Design that risk management models fail during crises, no matter how well designed they are. During a crisis, nothing else matters, other than who owns what, and who must sell even if they do not wish to do so.
“This is because any would-be seller has to find a buyer to take the paper off their hands.
“History tells us this is not always as easy as it sounds, as J.K. Galbraith’s magisterial analysis The Great Crash shows. In his study of 1929’s market catastrophe he notes:
“Of all the mysteries of the stock exchange there is none so impenetrable as why there should be a buyer for everyone who seeks to sell. October 24, 1929, showed that what is mysterious is not inevitable. Often there were no buyers and only after wide vertical declines could anyone be induced to bid. Repeatedly and in many instances, there was a plethora of selling and no buyers at all.”
“Galbraith cites White Sewing Machine stock as an example. It plunged from $48 to $11 and yet no buyers emerged. Eventually an enormous block of stock was sold for one dollar a share.
“It is tempting to dismiss this as the follies of a distant era, of some 90 years ago and more. But FTSE 100 stocks were extremely hard to sell in size in 2008. There is every likelihood that the next market upset, if, as and when it comes, could see further distressed selling, not least because of the use of leveraged instruments and margin, which smacks of the sort of risk-taking which makes market accidents worse as and when they happen.
“The hard bit is no-one knows when that will be.
“One sign could be a trend in margin debt.
“This has already tripped up a new generation of private investors in Korea, who have used margin or leveraged single-stock exchange-traded funds to pile into memory chip makers Samsung Electronics and SK Hynix. The Korean market briefly soared from being the fifteenth to the sixth biggest stock market in the world, powered by the valuations the two semiconductor companies, whose weighting within the KOSPI index peaked at 60%.
Source: LSEG Refinitiv data
“US investors seem no less hot-to-trot in their desire to maximise near-term returns, by chasing momentum stocks and using margin, leveraged ETFs and 0DTEs to do so.
“The latest FINRA data on margin, which covers June, shows that US investors, professional and private, have borrowed record amounts with which to buy stock.
Source: NYSE data to February 2010, FINRA data from February 2010
“It is tempting to dismiss this, by saying that the numbers are not as lofty when presented as a percentage of US stock market capitalisation. Bulls will take comfort from how margin debt represents only 2.3% of the S&P 500’s $64 trillion valuation compared to historic highs a lot closer to 3.0%.
Source: NYSE data to February 2010, FINRA data from February 2010, LSEG Refinitiv data
“But the rapid growth in margin debt is reminiscent of the market peaks in 2000 and 2007, to again show that risk-taking seems to be the order of the day. And it is this sort of risk-taking which makes market accidents worse, if and when they happen.
Source: FINRA, LSEG Refinitiv data
“Arguments that margin debt was not a concern owing to higher GDP or a larger economy saved no-one’s skin in 2007. The year-on-year growth rate in margin debt in the USA peaked the very month in which two Bear Stearns property-related funds went under, in June 2007, and overall margin debt managed one more month of growth before it began to shrink as the Great Financial Crisis began to develop and risk appetite started to shrivel.
“Risk appetite has been rampant of late, as evidenced by year-on-year growth in margin debt of around 50% in May and June, so it will be interesting to see if Situational Awareness’ ignorance of the dangers of leverage, concentration and liquidity spills over to other investors and prompts a period of circumspection or not.”
Source: NYSE data to February 2010, FINRA data from February 2010, LSEG Refinitiv data
