The New Titanic
In March, the hedge fund Archegos struck an iceberg. In just two days, the highly leveraged fund went from "business as usual" to total collapse. Performance rapidly degenerated; the fund was unable to meet margin calls; its bankers seized its collateral; the fund was out of business. Archegos lost everything.
Although Archegos was held only by founder Bill Hwang’s family, its saga offers broad investment lessons.
The Perils of Investment Courage
Victories can be hazardous. They present temptation enough for retail investors, who frequently, as the saying goes, confuse brains with a bull market. After making a couple of winning trades, it’s natural to assume that the trend will continue. The first two times I bought a stock, I doubled my money within 12 months. I had enough experience to know that some of that gain owed to luck, but not enough to know that all of it did. Never since then have I repeated that feat.
Imagine, then, the position of professional investors, who possess the additional hazard of occupational ego. Their livelihood depends upon their ability to best their rivals. Such competition is not for the timid; it demands a high degree of self-confidence, to overcome the lingering doubts. What’s more--although this point did not apply to Archegos, which operated privately--public fund managers face shareholder pressure to demonstrate “the courage of their convictions.”
Bill Hwang certainly showed the courage of his convictions. He grew the fund to $10 billion by borrowing mightily, and after that triumph, continued borrowing mightily. Estimates for the fund's final leverage ratio range as high as 8 to 1, meaning that even a modest loss would have consumed the fund's equity. Which is in fact what happened. Archegos wasn't destroyed by a huge bear market--it suffered what should have been a temporary decline, but which became permanent.
Pride went before the fund’s fall.
The Benefits of Investment Fears
The belief that fortune favors the bold also extends to stock sales. It is common to praise investors for holding fast when the news turns bad. "Sometimes, the Best Advice is 'Do Nothing'" states a U.S. News & World Report headline. "Why do nothing could be the best investment decision," explains Fidelity's website. And in the words of Jack Bogle, "Don't do something, stand there!" (Bogle's quote has since been transmogrified into the cleverer "Don't just stand there, do nothing.")
That is generally sound advice; I have given it myself. However, there are times when stocks resemble accounts at a savings bank that is undergoing a run from its depositors. Investors who cash out early receive their full proceeds, but latecomers do not. The highest return therefore comes to those who sell rapidly.
That is what occurred with Archegos's creditors. The investment banks that immediately dumped Archegos's collateral, after acquiring those issues when Archegos failed to meet its margin requirements, fared well. The banks that moved more slowly--Credit Suisse and Nomura--found themselves holding stocks that had been knocked down by their competitors' sell orders. They were forced to book investment losses.
To be sure, banks by necessity have a shorter attention span than do most retail investors. They cannot indefinitely postpone marking publicly traded securities to market, whereas retail buyers may have multidecade time horizons, during which only their psychology is damaged if the stock price declines. Nevertheless, the underlying lesson remains valid: Sometimes heading for the exits is prudent.
In the words of Matt Freund of Calamos Investments, "The first one out is not panicking. It doesn't make sense to join a panic, but sometimes it does make sense to start one." Harsh but true.
When Funds Drive Stocks, Not Vice Versa
Last spring, Archegos' top holding ViacomCBS VIACA traded at $18. By March 22, 2021, the company’s shares closed at $100. A 450% 12-month return, achieved through leverage, will do wonders for a fund’s performance. Had Archegos been publicly traded, Hwang would have been heralded for his investment savvy.
Upon reflection, though, it's not clear how much of Hwang's ViacomCBS profit owed to his knowledge, rather than his money. By March, Archegos reportedly controlled $20 billion worth of ViacomCBS shares, a whopping 30% of the company's total value. Clearly, the stock's gain owed not only to what ViacomCBS had accomplished, but also to the demand exerted by its major buyer.
This became abruptly evident on March 23, when the stock dropped 9%, as whispers of Archegos’s problems began to circulate. Over the next few days, ViacomCBS fell further, pressured not only by rumors but by sales from the fund’s aforementioned bankers. ViacomCBS’ stock now trades at $43; it has shed more than half its value over the past three weeks.
As Archegos was private, outside investors would not have been fooled into overrating Hwang’s abilities. But the possibility exists that some large public funds have also helped create their own success by pushing up the prices of stocks when purchasing them, which then improves the funds’ track records, which then attracts more capital, which then further boosts the stocks’ prices. And so forth.
The theme connecting these three observations is that investment truisms are imperfect. For the most part, investment conviction is helpful, holding tight after hearing bad news is sensible, and crediting portfolio managers for their results is correct. But, as the plight of Archegos shows, there are exceptions to the general rules. Regrettably, investing isn’t as easy as learning the right aphorisms.
The fund's tale of woe also sounds a warning about current market conditions. What applies to a single institution may also apply to a consortium of smaller investors bound together through social media. The stocks that they purchase may rise not because those firms are intrinsically superior, but instead because the group has affected their prices. With such stocks, it may eventually make sense to start a panic rather than to follow it.
John Rekenthaler (email@example.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.