price dip means that stop/loss procedures are being favoured over automated risk controls
Discretionary stop/loss procedures are increasingly being favoured over automated risk controls by hedge fund managers as markets are becoming more volatile.
Prices opening significantly lower than their previous day closures during October and November 2002 are highlighted as the main cause for hedge managers to look for added flexibility.
Single strategy and funds of hedge funds, particularly in long/short equities, are now being urged to view risk on a portfolio basis and place their trust in measurements such as Value at Risk (Var) during volatile periods. Var is a technique which uses the statistical analysis of historical market trends and volatilities to examine the likelihood that a given portfolio's losses will exceed a certain amount.
Ted Wright, vice-president of research and senior analyst at LJH Global Investments said: 'Some managers have said in these types of market environment, you need to be a little more patient and either waive your stop/loss limit or be patient in investing in stocks you have a truly high conviction of. This is probably an extremely tricky time for managers in the long/short area.
'If you are looking at a stock which is strong and it is on 18 cents, and 20 to 21 cents is a good price for it, but intra day you see it go down to 15 cents, you have to decide whether you hold onto it for longer. Managers are now looking at risk and risk management more on a portfolio basis.'
Charles Tritton, head of alternative investment at New Star, believes stop/loss for single strategy managers is better placed among high volume traders who play on much smaller spreads.
He prefers to use manager discretion rather than automated stop/loss. 'We might use stop/losses at key chart levels, when a stock is about to break out. For example, if we were a nervous holder of a short position that may go against us, we would cut the position and re-evaluate the situation afterwards to find out if we were right or wrong. Automatic stop/losses can be highly detrimental to a fund in a volatile market, so we use a subjective method.'
Mike Ward, chief investment officer at Franklin Templeton Investments, has not abandoned the automated stop/loss strategy. He said he will continue to use it but will mitigate risk by cutting or increasing the number of holdings in his portfolio depending on market conditions. He added: 'In our single strategy US long/short fund before January 2002, we were running the average long position closer to 2%, but by December 2002 it was closer to 1.4% on average size.'
Franklin Templeton's US long/short fund has also increased the number of positions it is invested in from around 80-90 to 100-110.
Ward said: 'Today, the problem can be you get a good long position name and the story behind the firm can change quite literally overnight.
'With our long positions the stop losses will trail the price but a stock can trade off 15% to 20% its previous day's close at opening. You could watch a stock close and at opening the next day be 35% down and there is nothing you could do. 'In addition, we trade in thirds, so if we buy 1.5% in a stock we would buy up 0.5%, then another 0.5% and finally another.
'If it creeps up to being 1.7% of the portfolio, we may pare the holding back to 1.5% to control the position risk we are taking on in any one company.'
The most common answer to questions on the validity of stop/loss and other controls, is that managers must find an acceptable level of risk, using Var as the means of expressing risk as a figure to investors.
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