Are Big Boys Still De-Risking?

Back in early May, when the European debt crisis was center stage and the fear was that “Credit Crisis II – When the PIGI’S Squeal” would bring the world to its knees again; we were introduced to a new term in the hedge fund community: Portfolio De-risking.

Up until the SALT Conference – a gathering of who’s who in the hedge fund world – investors were not familiar with this new-fangled term. In short, the idea of “de-risking” meant that managers were reducing their overall exposure to risk in their portfolios. We’ve always called this idea something simple such as “raising cash,” but then again, my hair is a bit grayer than most hedge fund managers these days and I don’t play all the reindeer games (i.e. derivatives) these guys do.

In hindsight, all the talk about de-risking in late-April, early-May appears to have been appropriate. Assuming the big boys were busy selling before, or at least during the early phases of the correction, they may have been able to lessen the damage to the May-June debacle in stocks. And with the S&P 500 dropping nearly 16%, the de-risking plan appears to have been a good one.

So, what are the “whales,” as the biggest hedge fund managers are called, doing these days? According to the FT, it appears that they are continuing to de-risk into the recent rally. John Paulson, the founder of Paulson & Co., which happens to be the third biggest hedge fund manager these days after his historic short of the U.S. housing market, is taking risk off of his firm’s portfolios.

At least part of the reason for some funds taking a portion of the turbo-boost out of their portfolio has to do with pretty crummy performance during the second quarter. According to the Q2 quarterly letter to investors, it appears that Paulson’s Recovery fund have been among the casualties of the second quarter downdraft as the fund declined a tidy -12.6%. (According to Hedge Fund Research, the average fund was off -2.5% in Q2.)

In response to the market’s increased volatility and the weak returns, the Recovery Fund has decreased its net exposure from 140% to 107% in recent weeks. (Net exposure, as you might surmise, is calculated by subtracting short positions from long positions.) Paulson’s flagship Advantage fund, which fell -6.6% in the second quarter, has also de-risked its exposure, which is now down to 67%.

In addressing performance, Paulson wrote, “A consequence of our portfolio positioning is higher short-term market correlation and volatility.” Thus, the de-risking would appear to be an effort to reduce the volatility of the portfolios in the current manic market environment.

So, should you follow the whales and begin de-risking your own portfolio? After all, the macroeconomic outlook isn’t exactly rosy and stocks have recovered at least half of the losses seen during the correction. Maybe, but then again, maybe not is probably the better answer.

You see, managers responsible for billions of dollars can’t reduce exposure quickly like you and I can. The old cliché among managers is you “sell when you can, not when you have to.”

On the other hand, the individual investor can move their entire portfolio from one position to another in a matter of a few clicks. And since our Daily Decision Model, as well as our bigger picture models, are still looking for more upside from this rally, we would advise some patience until sell signals are flashed.