Concerns Rise Over Hedge Fund Crowding Amplifying Systemic Risk in Times of Crisis

Market Risks Exacerbated as Hedge Funds Absorb More Market Volatility

A sudden equities rout on Friday has reignited concerns that the unwinding of crowded trades could amplify market losses. Despite reaching all-time highs in recent months, despite multiple wars and the specter of higher inflation, a group of semiconductor stocks driving outsized gains for the AI theme, leveraged ETF assets scaling new heights, and volatility dispersion remaining elevated, questions had started to arise about concentration risk and how it could exacerbate the next bout of market stress.

One central issue is the multi-strategy hedge fund model, where portfolio managers at different funds often end up clustered into similar trades. Although central risk management at the firm-level is stringent, external crowding in over-the-counter derivatives can be difficult to fully capture. A recent paper from the hedge fund Adapt Investment Managers emphasized the crowding risk, considering the hypothetical scenario of several multi-strategy pods positioned in the same trade, with a smaller pod liquidation triggering a domino effect for larger peers and exacerbating market impact as the trade unwinds.

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The booming structured notes market, driven in part by retail investors' hunt for ways to enhance yield, is also attracting attention. These debt-like securities carry a performance element tied to some other assets, often an equity index or single stock, and they're on track to exceed a record $1 trillion in total sales this year, according to data provider SP Intelligence, part of WSD. Autocallable notes stand out as the most popular, with global issuance up 45% year-on-year in the first five months, led by 64% growth from the US.

Banks structuring these products recycle the risk to mitigate their exposure to volatility and dividends, among other things. Trades done as back-to-back transfers essentially separate their origination and distribution from risk taking, with hedge funds stepping in to fill the gap. To David Elms, head of diversified alternatives at Janus Henderson Group Plc, the shift "represents the logical end point of the process" since banks seek to transfer individual risks "that caused them the most problems."

However, this shift may introduce a peril to the broader system. "One potential worry is the interaction with mechanistic and aggressive stop-loss programs, which may seek to aggressively sell complex and illiquid autocallable structures, risking risk-liquidation spirals," Elms said. "We will only find out the holes in the back-to-back autocallable transfer model when there is a crisis."

Antoine Bracq at R-Squared Global says hedge funds are adept at managing these kinds of risks. Individual portfolio managers operate within tight, real-time limits that are enforced by centralized risk teams, he said. "The risk of a concentrated blow-up is materially less likely today," he said. "The legitimate systemic question is not the pod model itself, but managing crowding and leverage at the platform level, which regulators are right to monitor."

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Before 2008, banks generally held more of the risk generated by the products they structured, using their balance sheets to warehouse exposures over time. However, as more bank alumni moved to hedge funds to set up exotic derivative desks, the financial institutions increasingly laid off the entire autocallable risk via back-to-back transactions, leaving hedge funds to manage the risk. In turn, that's allowed the banks to offer more products to their retail clients.

"This has allowed banks to transfer the risk off their balance sheets and, in turn, increase structured-product issuance to a new record high," said Ramon Verastegui, founder and chief investment officer at Kairos Investment Advisors. Of course, that could lead to a systematic crisis if different multi-strategy funds with similar positions behave in a similar way all at the same time, according to Adapt CIO Alexis Maubourguet and chief executive Clément Mary-Dauphin.

While the transfer of risk is making the market healthier in a way — no single institution carries systemic concentration — hedge funds don't have the same resources or infrastructure as banks do, warned Uriel Kutnowski, co-head of equity and derivatives at Stellar Securities. "Unlike 2020 or 2008, the current market structure — with pods, quant market makers and recycled structured product risk — is essentially untested at scale," Kutnowski said. "We simply don't know how redemption pressures, margin calls and gamma unwinds interact in that environment."