In late March, shockwaves reverberated across the US stock market. By Friday, 26 March, several prominent American stocks had fallen suddenly and steeply. In days, tens of billions of dollars were wiped from valuations. As investors scrambled to explain this turmoil, they discovered the culprit: Archegos Capital Management.
Archegos blows up
Bill Hwang was a successful trader at Julian Robertson’s renowned hedge fund Tiger Management. When Tiger closed in 2000, Hwang started Tiger Asia Management (TAM). This hedge fund closed in 2012, after an insider-trading conviction. In 2013, Hwang launched Archegos, his family office. It was a quiet success, notably making enormous sums since March 2020. At his peak, Hwang may have been worth $15bn. Then, in one week, Archegos blew up. Following a fire sale of its assets, the fund may be left with very little or nothing at all. Here’s what went wrong, in three easy lessons for all investors.
A highly concentrated portfolio…
To maximise returns, Hwang ran a highly concentrated portfolio. Using financial derivatives bought from investment banks, he held large stakes in a few companies. These included leading US media businesses, plus several US-listed Chinese groups. When ViacomCBS shares started sliding on Tuesday, 23 March, they quickly went into freefall. They collapsed from over $100 to $45, crashing by more than half (55%) in four days. This slashed tens of billions of dollars from the group’s market value.
With Archegos being one of ViacomCBS’s biggest shareholders, lenders demanded more collateral to support this and other losing bets. When traders fail to deliver collateral, they get a ‘margin call’ (an immediate demand to pay). When Archegos failed to meet margin calls, this triggered a massive fire sale. Banks sold huge chunks of the Archegos portfolio at big discounts in large ‘block trades’. Very quickly, Archegos racked up losses of many tens of billions of dollars in this forcible liquidation.
…Using too much leverage…
The second problem was Archegos used far, far too much leverage. Leverage involves using borrowed money or financial derivatives to magnify gains (and losses) from trades. I always say leverage is a double-edged sword, because it can harm as often as it helps. Hwang was said to be leveraged 5:1. Thus, for every $1 of assets, he took on $5 of risk. In this scenario, should a portfolio’s value fall by a fifth (20%), then it gets completely wiped out. It was this frightening leverage that set fire to Archegos, sending it up in smoke. As I warn: “Leverage is your best friend, until it’s your worst enemy.”
…Put Archegos in a liquidity trap
The third problem follows on from the first two mistakes. When running a highly concentrated, aggressively leveraged portfolio, it can be like a lobster crawling into a lobster pot. It’s easy to get into, but incredibly difficult to get out of. When forced to sell large shareholdings in a hurry, an investor gets a reduced price far below prevailing market rates. When caught in a liquidity trap, being a distressed seller means losing an arm and a leg.
Those are my three lessons from this debacle. But it’s so easy to avoid these problems. 1) I’d keep my portfolio highly diversified by spreading my eggs across many baskets. 2) I wouldn’t use leverage because I don’t like getting torched. 3) I wouldn’t take such large positions that I’d get caught in a liquidity trap!
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