Recent comments from Bank of England Governor Andrew Bailey have brought to light a pressing concern regarding multi-manager hedge funds, such as Citadel, Millennium, and Point72.
Citadel, who has been highly scrutinized by retail investors is one of the world’s largest asset managers and hedge funds.
In 2023, it was the second largest multi-strategy hedge fund globally.
These funds, known for their strategies and complex structures, are increasingly seen as a potential threat to financial stability.
As they grow in prominence, the risks associated with overleveraged bets and market manipulation pose significant challenges, particularly for retail investors.
Understanding Multi-Manager Hedge Funds
Multi-manager hedge funds, often referred to as “multistrats” or “pod shops,” operate by pooling together various trading strategies within distinct teams or “pods.”
Each pod specializes in a specific investment approach, promising diversification and steady returns.
However, this structure can create systemic risks in volatile market conditions.
As Governor Bailey noted, these funds can exhibit correlated behavior, meaning that when one pod decides to deleverage rapidly, it can trigger a domino effect across the entire fund.
This coordinated rush to liquidate positions during market shocks can exacerbate volatility and lead to significant market disruptions.
“Multi-manager funds can make individual ‘pods’ deleverage rapidly in stress conditions, which can exaggerate market moves,” Bailey said in a speech at the University of Chicago Booth School of Business in London on Tuesday.
“There could be circumstances in which the means by which multi-manager funds protect themselves in this respect can create risks to the system.”
Bailey’s comments prompted push-back from the Managed Funds Association, which represents the alternative asset management industry including hedge funds.
“The structure of hedge funds enhances financial stability, as hedge funds have no government backstop, no liquidity mismatch, and losses are siloed to an individual fund and its sophisticated investors,” Jillien Flores, MFA Head of Global Government Affairs, said in an emailed statement.
“Regulators have visibility into the activity of hedge funds through existing regulatory reporting and the funds’ broker-dealer counterparties.”
However, this isn’t entirely true, and the hedge fund industry has been fighting the SEC for years now to suppress transparency.
In a recent statement, SEC Commissioner Caroline A. Crenshaw expressed serious concerns over the agency’s decision to scale back the Consolidated Audit Trail (CAT) system, a vital tool designed to enhance market transparency and protect investors.
Commissioner Crenshaw emphasized that reducing the data collected by the CAT effectively “wipes away the fingerprints from the scene of the crime.”
By stripping regulators of essential information, the SEC is making it more difficult to identify fraudulent activities and market manipulation.
The Risks of Overleveraging
One of the key issues with multi-manager hedge funds is their propensity for overleveraged bets.
By borrowing extensively to amplify returns, these funds increase their exposure to market fluctuations.
While the allure of high returns can be enticing, overleveraging can lead to catastrophic losses when markets turn against them, as seen during the ‘meme stock’ frenzy of 2021 with GameStop and AMC.
Related: “The Game is Rigged”, Says Ex-Citadel Data Scientist
The collapse of Archegos Capital in 2021 serves as a stark reminder of the dangers associated with excessive leverage.
Archegos utilized heavy borrowing to finance its investments, leading to a massive sell-off that impacted multiple banks and caused significant turmoil in the stock market.
Founder Bill Hwang is now serving 18 years in prison.
Such incidents raise concerns about the stability of financial institutions that may be exposed to similar risks through their dealings with multi-manager hedge funds.
Systemic Risks and Retail Investor Impact
The rapid growth of non-bank finance, particularly multi-manager hedge funds, has drawn the attention of regulators worldwide.
The Bank of England’s exploratory scenarios suggest that hedge funds and asset managers may be ill-prepared for potential crises, highlighting a need for more stringent oversight.
Retail investors, who typically lack the resources to navigate complex market dynamics, are particularly vulnerable to the negative impacts of these funds.
The manipulation of stock prices by large hedge funds can create an uneven playing field, where everyday investors find themselves at a disadvantage.
Practices such as aggressive short selling and market manipulation can distort stock valuations, leading to significant losses for retail shareholders.
Related: Prosecutors now indict 3 traders for naked short selling
Cheating Retail Investors: Market Manipulation Tactics
Multi-manager hedge funds are often accused of employing tactics that undermine market integrity.
For example, through coordinated trading strategies, these funds can artificially inflate or deflate stock prices, impacting the buying and selling decisions of retail investors.
This manipulation not only erodes trust in the markets but also leads to financial losses for individuals who lack the insight or influence to compete effectively.
Moreover, the opaque nature of hedge fund activities makes it challenging for regulators to monitor and address these practices.
Retail investors may unknowingly become victims of price manipulation, forced to buy at inflated prices or sell at depressed values, all while hedge fund managers profit from the discrepancies.
The Path Forward: Enhancing Regulation
The rise of multi-manager hedge funds like Citadel, Millennium, and Point72 presents significant risks to financial stability and retail investors alike.
With their complex structures, overleveraged positions, and potential for market manipulation, these funds can exacerbate volatility and undermine trust in the financial system.
It is essential for regulators to recognize these threats and take decisive action to safeguard the interests of everyday investors, ensuring a fair and transparent market for all.
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Related: SEC Commissioner laments agency’s decision to fight against CAT system
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