Waddell & Reed and the crash of 2:45

the Ivy Asset Strategy Fund

Government investigators have  been tracking the sell orders that were executed in Chicago on the afternoon of May 6 betweeen 2:30pm and 3:00pm, the period when the S&P 500 plummeted by 5%–and just as quickly rebounded.

According the Financial Times, they’ve discovered that a mid-Western investment firm, Waddell & Reed (ticker:  WDR), was a significant seller of stock index futures during that period.  At one point, 2:32pm, WDR constituted 9% of the total volume of one specific stock index futures contract, the “e-mini”.   WDR has issued a press release (not so easy to find on its website, but it’s there) confirming  the press stories and stressing it was just doing normal hedging transactions for its $22 billion flexible fund.

The prospectus of the fund in question, the Ivy Asset Strategy Fund, says it can invest in stocks, bonds, precious metals and currencies around the world.  It can also use derivatives to hedge its exposures.  In other words, the customer gives WDR enormous freedom in how to invest his funds.

Neither the WRD press release nor the fund prospectus spells out what the fund might have been doing on the afternoon of May 6th.  The only clues we have are that the WRD selling seems to have been triggered by the declining market (rather than vice versa) and that the selling continued even as the market was rebounding.

This suggests, to me anyway, that the selling was done in accordance with mechanical rules that were set in advance, and were to be carried out without any human intervention.  The idea would be to remove human subjectivity–feelings of greed or fear–that might lead to impulsive (and thereby usually money-losing) on-the-spot action.

dynamic hedging

the investment manager

The simplest explanation of the activity is that the managers were using a plain-vanilla technique for hedging portfolio value where the short derivatives position shrinks as the S&P rises and increases as the S&P falls (it was called portfolio insurance when it became popular about a quarter-century ago).

There’s nothing “wrong” with this technique or exotic about it–in fact, it’s ubiquitous in the hedging world–other than that it was invented by academics.  An underlying assumption is that there’ll always be someone (you can call him the “dumb money,” if you want, because that’s the idea) who will willy-nilly take the other side of the trade.  And, I suspect, when the WDR computer/trading room entered its sell orders, along with about 250 other firms who were using similar techniques and wanted to do the same thing, there weren’t enough buyers to go around.

Two points:

1.  The investment manager sees the market declining and sells S&P index futures to hedge his position.  The counterparty, who is likely the broker he is dealing with, takes the offsetting long position.  If it’s the broker, he will try to balance ( or “flatten”) his books by selling stock short in the physical market, thereby creating further downward pressure on the S&P.  In addition, if he already has a long futures position and is employing the same hedging technique for his own books as the investment manager is, he wants to sell more physical stock short to restore the level of hedging he wants against any long futures position he already had.

This means the market declines further, the investment manager wants to hedge more …  The investment manager hedging activity has a snowball effect.

2.  This kind of hedging has been around for about 25 years.  If it still works–it’s possible it doesn’t and that practitioners lost their shirts on the 6th  (warning:  my practical derivatives experience is limited to currencies and emerging markets stocks), it seems to me to depend on the assumption that the counterparty never catches on.  He never alters his behavior  He never reads the books his customer studied from.  He never tries to hire away one of his traders to learn his secrets.  He just continues to be the “dumb money” who racks up losses from this trading.

Not likely, though.  It’s possible that the counterparty makes so much money from his customers’ other, losing, trades that he writes this off as a cost of doing business.  More probable, I think the counterparties model their customers’ actions very closely–after all, everyone is doing basically the same dynamic hedging trading–and can predict with a high degree of accuracy when they will act and what they’ll do.

The counterparty has three responses that I can see.  He can charge more for trades done at times he identifies as risky.   He can begin his own hedging activity in anticipation of his customers’ acting (in effect triggering their trades).  Or he can drag his feet in executing them so that he ends up not doing them at all, or not doing as many as he would otherwise do.

the counterparties

I think there should be a debate about what obligations, if any, an exchange, or a broker who is a member of an exchange, have in a situation like this.  This is particularly so, since we are enacting legislation to force most derivatives trading out of the shadowy over-the-counter world and onto exchanges.

We do know that the NYSE partially withdrew from making markets during the decline on May 6th.  Members did so by unhooking their computers as the market was falling and starting to process trades manually.  They certainly avoided losses by doing so.   Given how they are connected to the stock index futures markets, this short-circuited the derivatives world, as well.  Should they be allowed to?

The NYSE is a particularly interesting case.  On the one hand, you could argue that they are a quasi-utility that can’t be allowed to in effect turn out the lights in tough times.  Given that it has a history that I would characterize as one of high fees and shoddy service, it wouldn’t be surprising to learn it has few friends among professional investors.

On the other hand, the NYSE is by no means a monopoly.  Professionals have been bypassing it for years, through electronic crossing networks, for instance, that offer lower costs and greater confidentiality.  The issue with ECNs is that they aren’t that liquid.

the debate should be interesting to watch

How do you reconcile the interests of a derivatives community operating with tools that presuppose infinite liquidity at all times, with a creaky physical stock trading system where the taps can be turned off at a moment’s notice?   We’ll see.

By the way, I don’t think the Ivy Asset Strategy Fund did anything wrong.  Its only sin is that its performance, along with WDR’s marketing, have grown it to such a large size that its actions are more visible than its peers’.

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