The term “hedge fund” was coined by sociologist Alfred W. Jones, who set up a fund that would “hedge” against the risks of market-wide crashes on his investments. By combining leverage and short positions, Jones devised a “conservative” financial instrument that was supposed to be neutral to the market.
However, hedge funds run by investment experts alone were not able to fully eliminate risk from investments. Risk is inherent to all investment decisions, and adding to that the peculiar human biases and errors, and the dangers are even more apparent.
Humans and human nature are prone to behavior that can bring suboptimal results, often driven by psychological biases or emotions. This, more often than not, causes serious errors, which, at its worst, lead to hedge fund meltdowns.
Tiger Funds
Emotion has been seen as one of the key elements of a downfall for a number of investors—when they are in an emotionally motivated state, investors are more likely to employ irrational strategies. These include chasing losses, doubling down, revenge betting and other suboptimal bets. It happens because of the innate human tendency to ascribe intent to everything, including stocks.
Most would expect that investors such as hedge fund managers are beyond those emotional influences. In fact, they may be the ones most at risk.
Investors are at risk of losing their most valuable asset, their reputation. That’s why when their predictions don’t pan out, many stubbornly stick to their contrarian bets, even if it costs them billions.
Julian Robertson of Tiger Management stuck to a strategy of “buying the best stocks and shorting the worst.” However, at the height of the tech bubble, the worst stocks just wouldn’t drop.
The fund continued to sustain losses as Robertson was betting against the market. The fund liquidated in March 2000, at the peak of the bubble.
Tesla Short Sellers
The market has also burned hedge funds that shorted Elon Musk’s EV manufacturer Tesla. None was as committed to the Tesla short position as Mark Spiegel of Stanphyl Capital, calling Tesla “the biggest bubble in modern stock market history.”
The fundamentals may agree with the shorts, but that hasn’t stopped the stock from surging over 695% in 2020. Collectively, Tesla short sellers are down $11.1 billion since 2016.
Spiegel may have been right about the fundamentals, but he still lost money on the trade—and he’s not alone. Michael Burry of Scion Capital called Tesla’s valuation “ridiculous,” and discussed a 90% drop in Tesla’s share price.
The fight between the short-sellers and Tesla has been described as “cultish on both sides.” Short-sellers like Spiegel decided that they needed to “prove” their positions and double down, which led to continued losses.
Amaranth Advisors
Human traders excel at finding creative strategies that generate profits for themselves and their investors. However, that same creative capacity can spell disaster if their incentives are not aligned with those of the fund.
That’s what caused the Amaranth Advisors billions in losses. Brian Hunter, its chief energy trader, is reported to have repeatedly doubled down on his bets with borrowed money. He used the fund’s money to buy futures that the fund had already owned, boosting gains.
However, the gains would stay up only if the lenders were willing to buy more contracts. In 2006, once the lending had stopped, the position was revealed as a colossal loss.
Hunter’s misaligned incentives and bias allowed him to mistake paper gains for cash profits. The fund lost $5 billion on his trades, and had collapsed shortly thereafter.
Deutsche Bank $6 Billion “Fat Finger” Error
The fat finger error is what first comes to mind to most people when considering human errors in trading. This happens when the operator mistakenly inputs the wrong parameters in the system, perhaps by pressing the wrong button.
This is what happened when Deutsche Bank mistakenly sent $6 billion to one of its hedge fund clients. Reportedly, this happened because a junior foreign exchange trader misunderstood instructions for a much smaller payment.
While these errors are usually harmless, they can have a significant impact. Fat finger error was implicated in the 2016 British Pound crash when the currency dropped 6% overnight. However, automated trading could also have contributed.
In practice, most hedge funds have alerts set up that track when a trade is outside normal market parameters.
Human Error: More Dangerous than Ever?
The inherent risk that stock trading carries is in part tied to human errors, which continue to exist today, as they have moved from the emotional field to the digital.
The main lesson learned in these situations is the need to find solutions that could curb these errors and minimize losses—automating investment principles is one of them. Only by systematizing and properly describing the investment strategy and entrusting it to a computer can critical investment mistakes be lessened. Bringing algorithmic or quant trading to hedge funds, as Stokex does, is now more widely accessible than it was decades before.
That is why successful investors use more or less sophisticated sets of predetermined rules of trading like quant trading and apply them consistently. This in large part prevents making rash, emotional decisions that sometimes don’t take the entire picture into the account.
The lessons of high leverage, however, have not yet been learned, as increasing computer competition is forcing the recruitment of more and more borrowed capital to ensure a sufficient return on equity.
