Every so often, a hedge fund will blow up so spectacularly that it affects the entire market.
Over the last few weeks, the implosion of Archegos — a family office investment organization — caused some huge losses for key stocks in the market.
More importantly, it rattled the nerves of many investors and could have some ripple effects for some time to come.
If you’re one of the many retirees managing their own investments, I want to make sure you understand what’s going on.
And I want to make sure that you know how to sidestep the risks that these types of aggressive traders have built into the market.
As a bonus, we’re also going to talk about a safer way to add extra firepower to your investments to get some of the benefits of aggressive trading — without the dramatic risks.
I’m excited about the topics we’re going to cover today!
Related: Options Trading Part 2: Taking Advantage of Financial Leverage
Excessive Leverage Leads to a Spectacular Blowup
Situations like the one with Archegos give hedge funds a bad name.
While the family office wasn’t technically registered as a hedge fund, the investment firm basically operated in the same way that many speculative non-regulated hedge funds do.
Archegos used financial leverage to take the capital it had available to invest and make much larger bets in the market.
While the details are still being sorted out, I can tell you the basics of how these transactions work.
When I was a hedge fund manager for a very conservative fund that managed risk carefully, we would be approached by brokers all the time asking if we wanted to use leverage to take more aggressive positions.
In the hedge fund world, brokers like Goldman Sachs, Morgan Stanley, Credit Suisse and others are willing to lend extra money to help funds buy and hold large positions compared to the amount of money they manage.
For instance, while the fund Archegos was reportedly worth $10 billion, the fund held stocks worth many times that amount.
Here’s how it works.
A fund like Archegos sets up an account with a broker like Credit Suisse and deposits the $10 billion into the account.
Credit Suisse then lends extra money to allow the fund to buy larger and larger positions. In the case of Archegos, multiple brokers lent the company money so it was able to spend $40 billion, $50 billion, or even more cash on shares of stock.
Eventually, the hedge fund will have to pay back the debt. But in the meantime, the fund is responsible for all of the profit or loss from these larger positions.
Let’s assume Archegos was lent enough money to buy positions that were worth $50 billion.
If those positions rose by 10%, it would result in a $5 billion profit for Archegos.
That’s a huge gain compared to the $10 billion the company started with. In fact, a 10% rise in the company’s investments leads to a 50% gain on the fund’s value.
Brilliant!
But unfortunately, this leverage works in reverse as well.
A 10% decline in the fund’s investments winds up causing Archegos to lose 50% of its value.
And by the time these positions trade lower by 20%, Archegos is worth nothing and out of business.
And that’s when things really start getting dangerous.
The Ripple Effects of a Hedge Fund Failure
Remember those brokers who lent money to Archegos? Well now that Archegos is out of business, these brokers are in a world of hurt.
Brokerages like Credit Suisse aren’t going to be paid back by Archegos. But they still have shares of stock that were held in Archegos’ account.
These brokers must sell the shares because it’s their only hope of getting something back for the loan they’ve extended to a now-bankrupt fund.
All of this selling naturally drives prices of the stocks that used to be held by the fund lower.
In the case of Archegos, the biggest stocks being sold were ViacomCBS (VIAC), Discovery (DISCA), Baidu (BIDU) and Tencent Music (TME).
Wall Street can be a vicious place. And when news gets out that there’s a “forced liquidation” going on (or stocks that must be sold), other investors holding those positions can also sell quickly to get out of harm’s way.
At the very least, big buyers will step away from those stocks and wait for the selling to be done before stepping in to pick up shares at cheaper prices.
This “buyers strike” is part of what caused shares of these media and Chinese tech companies to plummet as the positions were liquidated.
But it’s not just these stocks that got hurt.
Brokers like Credit Suisse (CS) and Morgan Stanley (MS) have traded sharply lower because it’s now becoming clear that these brokers will lose billions from this blowup.
So if you’re an investor holding shares of these banks, you’ve unfortunately been hurt by the irresponsible trading from this family office — and irresponsible lending on the part of the brokers.
The final straw is that after a big blowup like this, brokers typically start getting a little more careful about how much they’re willing to lend to hedge funds and other speculative traders.
When these brokers decide to cut back on how much they lend out, hedge fund customers will be forced to sell positions that have been bought with this borrowed capital.
Or at the very least, these speculative traders won’t be able to buy more of these stocks with borrowed cash from brokers.
With these hedge funds cut out of the market, we could see additional selling in some of the more popular growth stocks that speculative traders have been holding for the last year.
Protect Yourself From “Popular” Stocks
Whenever you have a situation where certain investors may be forced to sell shares, it’s important to make sure your investments are out of harm’s way.
This weekend, I took some time to do research on which stocks are heavily owned by hedge funds to figure out what positions would be most vulnerable.
When it comes to stocks held by these hedge funds, I place the names into two categories.
On one hand, there are companies running financially responsible businesses, paying reliable dividends, and growing profits over time.
Many of these stocks are popular with hedge funds because they can be foundational positions that help generate gains year in and year out.
If these stocks trade lower as a result of hedge funds being forced to liquidate positions, I’d encourage you to buy them.
Because once the selling is over, these stocks will once again trade higher and the volatility shouldn’t affect the businesses (or your retirement).
Some of the stocks in this category include Apple (AAPL), Verizon (VZ) and Intel (INTC). These stocks are great investments for various reasons.
AAPL has a huge cash balance and should increase its dividend over time.
VZ will benefit from the global 5G rollout.
And INTC is undergoing a turnaround process that could lead to a sharp rise in profits.
On the other hand, the more speculative stocks held by hedge funds are names you should avoid — or at the very least, hold carefully and be willing to sell if they start to break down.
Some of the stocks in this category include Shopify (SHOP), Tesla (TSLA) and Palantir (PLTR).
I won’t be surprised if you take exception to me mentioning these names.
While these names (and other speculative hedge fund favorites) typically have exciting business models and plenty of growth ahead of them, their sky-high market valuations pose a danger.
If hedge funds are forced to liquidate some of these positions, the entire market’s enthusiasm for these popular stocks could quickly evaporate.
And that could send shares sharply lower for a long period of time.
Don’t let a pullback like that hurt your retirement savings!
A Better Way to Use Leverage
While the recent hedge fund blowup is a good reminder of why too much leverage can be so dangerous, there are some good ways to use financial leverage to accelerate your investment returns.
Instead of borrowing money and buying stocks on margin, I personally prefer to use options contracts for the more aggressive trades I place.
When you buy a call contract, you’re entering an agreement that allows you to buy shares of stock at a specified price.
That agreement can fluctuate quickly depending on the underlying price of the stock.
And if you use options wisely, these contracts can help drive large percentage gains in your investment account.
A few weeks ago, I wrote an education series on options. If you’d like to get up to speed on these special investment tools, you can start with Part I of the series here.
The great thing about options contracts is that you can only lose the amount of money that you invest in the contract.
And since these investments can be so lucrative, you don’t have to invest much in any one options play to generate profits that make a big difference for your retirement.
Once you learn how to use options to accelerate your profits, I love the idea of holding the majority of your wealth in stable dividend-generating stocks.
Then you can add a few powerful options plays to that foundation.
These options plays give you the benefits of the financial leverage that hedge funds use without the major risk that has caused too many funds to blow up.
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