The Archegos Capital Meltdown Lifts the Lid on Longstanding Risk Management Flaws
From TABB Forum:
The downfall of Archegos Capital has shown that investment managers have to, at the very least, have some insight into complex derivatives if they are to harbour any hope of calculating the potential risk underpinning bigger and more liquid stocks in the future, writes Joseph Cordahi, Product Strategy Director at NeoXam. Mr. Cordahi looks at issues related to risk management in Archegos’ meltdown.
The exposure Archegos Capital, a family office that collapsed after failing to make its margin calls on numerous large leveraged bets, had to Viacom and other stocks really does open a Pandora’s box worth of issues surrounding the use of total return swaps in today’s global equity markets.
Viacom, the stock that Bill Hwang’s fund was most exposed to, is not exactly a mainstream technology stock like a Microsoft or Amazon. The downfall of Archegos has shown that investment managers have to, at the very least, have some insight into complex derivatives if they are to harbour any hope of calculating the potential risk underpinning bigger and more liquid stocks in the future.
What was interesting about Archegos is that there were no obvious investment fundamentals to indicate why the Viacom stock rose above $100 per share, before it reversed sharply. We now know it was due to total return swaps, and the reason market participants like to use them is anonymity. Investors want to get in and out of positions quickly without tipping off the market when building a position.
It’s also a reporting issue: Institutional investors, including hedge funds, in the U.S. are required to disclose their positions each quarter to the SEC. Consequently, hedge funds in particular want to avoid disclosing their large positions, so the wider market doesn’t know what they own in their portfolios.
Total Return Swaps enable hedge fund managers a creative way to avoid disclosing their exact position, and thus protect themselves from a Melvin Capital/GameStop situation. Of course, everyone is familiar with Melvin Capital, when it became the target of a short squeeze earlier this year during the GameStop frenzy.
Archegos, however, was not technically a hedge fund. It was a family office. Therefore, its disclosure requirements were less transparent by definition. This lack of disclosure presents a real problem with instruments as complex as the total return swaps deployed by Archegos. Investment managers need to understand the underlying security behind the swap to calculate the risk.
Regardless of whether it is a single stock, or a basket of securities, a much more granular insight into exactly what is behind the derivative is required. This is because complex investment vehicles, with new instrument or trade-related data information, need to be quickly defined within custom-made templates before they can be incorporated into a global investment process.
Archegos clearly had no such system in place. It represents a much needed a wake-up call to the wider investment management industry. As the SEC continues to look over rules around disclosure and transparency, fund managers also need to start assessing the situation. It is no
good relying on an SEC filing, this does not paint a full picture in terms of what may be underpinning the stock. The reality is that, in an investment world that has never been more complex, investors desperately need regular insight about a fund’s investment approach.
Joseph Cordahi is Product Strategy Director at NeoXam. Joseph is responsible NeoXam’s longterm investment management strategy globally, with the support of all product experts in the group. He has over two decades worth of experience in the data management space.