Liquidity is an issue, and most people do not think about the liquidity factor until it’s too late, including risk managers.
Two takeaways from Friday’s sessions;
1, the extreme px axction in Baidu, Tencent Music, Vipshop, Viacom, Discovery, Farfetch, iQiyi and GSX. For more reading on who and how they sold these positions see here. One thing is sure, when even big names trade with this type of liquidity, stability does not come to our minds as one of the strong factors of this market.
2, the second observation is that despite these names oscillating massively, market shrugged off this and squeezed into the close.
It does not matter who was behind the original sales of these stocks, but more importantly is to consider the illiquid market environment we are living in.
Even seasoned fund and risk managers tend to get surprised when things go the “impossible” way.
Regular readers of TME know our take on last year’s hottest fund, Ark-funds.
We have covered ARKK in various notes over the past months. On Feb 17 we warned our readers about the ARKK hype as we wrote;
“ARKK – everybody worried not enough stuff to buy…
…but looks like people should care more about how it behaves when they need to sell.
ARKK, investing in stuff that “changes the way the world works”, but as always you need to ask yourself at what price are they changing the world, as well how does it behave in terms of liquidity on the way down, just in case.”
Since then ARKK has crashed by some 25%. The “stress” of not enough things to buy has turned into discussions of how to manage the downside risks.
On March 15 ARK released a video discussion, A Capacity & Liquidity Analysis by ARK Invest
TME’s take on the 1 hour video was basically as outlined here. We wrote;
“Needless to say, but having three “ARK people” including the big “boss” talk about her own funds and liquidity is hardly an objective approach to risk and liquidity management.
How do they manage downside risk is basically, according to Cathie;
“..we will put in more large cap stocks in the portfolio….which we see as cash….when risk off hits the market….we sell “cash stocks”…”
Go figure what the funds will end up with if things turn properly sour….Highly illiquid stocks impossible to manage.
Anyone that has managed a big book of illiquid assets knows how hard these “things” are to manage.
During this one hour presentation there is a lot of mentions of “if we are right”…but not one mention of “if we are wrong.
Anybody talking about risk and liquidity management that does not talk about “what if we are wrong” has little clue about real risk management.”
Huge funds that have to release video presentations of how they manage the downside should probably be a warning sign itself.
The number one rule in managing risk is to “master” your downside in order for your p/l to not fall too much. After that lesson comes various other aspects of how to optimize your p/l on the way up (i.e what and how do you do when your trading is doing well).
Anyway, first chart shows performance of the top 10 names in ARKK since mid Feb. The best one is believe it or not Tesla, down 22%.
Second and third images show the ARKK top 10 names in terms of size. Bidu was ARK’s biggest buy last week. Only on Friday ARKK added 323,410 shares to ARKK, and total BIDU longs to the ARK “family” on Friday was around 545k shares.
Cathie buying more of a crashing stock she is already very long is the classical averaging down strategy, which is a very dangerous strategy. Sure, Bidu and other crashed ex hot names could bounce, but that is not how you conduct risk management. That strategy is based on hope and NOT efficient risk management.
ARKK is down from 160 to 114 in little more than a month. 200 day moving average is down at 106. Our logic from mid Feb (see above) continues to hold. Obviously the price is down a lot, but the bigger picture problem is how does ARK funds start behaving should we see more of those moves we saw on Friday?
Averaging down is the casino mentality so many traders and portfolio managers get “stuck” in. Focus goes from managing risk to justifying with fundamental reasons why you have a position on and add to it when it goes against you. This becomes a dangerous game when you run external money.
Imagine bigger redemptions would hit some of Cathie’s funds? After all external money does not care how you performed 1, 2 or 5 years ago. They want you to always perform.
The biggest problem with adding to losing trades is the fact that “making it back” is extremely much harder than following a rigorous p/l management methodology.
After all, losing 40-50% is not hard (just look at TDOC in ARKK’s portfolio, down 40% since mid Feb), but in order to break even on a 50% draw down, you have to make “back” 100%. How easy is it to make 100%?
Last image shows the simple table of how much you have to “make back” in order to break even on an X initial loss. Nothing new really, but few think about it, and even fewer have a method of how to manage it (not to mention how few people know how to behave when things go your way, ie adding to good p/l by expanding risk).
Instead, people tend to trade constant risk (totally wrong), and are happy to average down instead of averaging “up” (adding to winning p/l).
More on all of this later, but for now we ask ourselves will Cathie’s ARK need to be placing stocks at discounts should liquidity become a real issue?