What We Can Learn From Archegos Capital's Downfall

Reports are circulating that Bill Hwang's Archegos Capital was behind last Friday's trading frenzy, where many large-cap stocks slumped in value.

Most of the reports coming out at the moment are not based on concrete evidence, only speculation, so we don't know the true scale of the issue. However, two large banks, Credit Suisse (

CS, Financial) and Nomura (

NMR, Financial), have both admitted that they're likely to lose large sums due to the firm's trades.

These banks are on the hook because it seems as if Archegos was borrowing vast amounts of cash to fund leveraged trades from these institutions.

One report suggests the hedge fund may never actually have owned most of the underlying securities.

Instead, it gained exposure to the equities through so-called contracts for difference, or CFDs. These are essentially privately arranged contracts linked to the price of a security where the differences in the settlement between the open and closing trade prices are cash-settled.

CFDs allow traders to take significant positions without alerting the market. They also allow traders to borrow vast amounts as the only limiting factor is how much the counterparty is willing to lend.

The risks of these kinds of instruments are twofold. First of all, there's the amount of leverage involved, and then there's the fact that no one really knows what is going on.

To illustrate the point, Archegos was apparently able to take large positions in the stocks with different prime brokers without alerting each party to the scale of its stake. If Archegos had acquired similar-sized positions via the traditional route, it would have had to report ownership stakes over a certain level and publish holdings on a 13F report.

The lessons from the collapse

There are two significant lessons investors can take away from this situation, even though we don't have all of the information as of yet.

The most obvious is the danger of leverage. Reports suggest Archegos' leading brokers had to liquidate substantial blocks of stock on Friday.

The selling was so intense they were taking offers at any price. That's why the prices of stocks like Discovery (

DISCA, Financial) (

DISCK, Financial) dropped more than 30% in one day. It was a fire sale.

The hedge fund didn't have any control over what was happening, and therefore couldn't achieve the best price. It had to take what the market was offering, which in this case was as much as 30% lower than it was expecting.

This is the single most considerable risk of using leverage. An investor can look very clever borrowing money to invest, but creditors can take control if the situation does not work out as expected. When creditors take control, the investor's options become limited and they have to take whatever is offered. No one ever wants to be in that situation.

Opaque investment funds

The second takeaway is that while 13F reports and hedge fund letters might give us some idea about the kind of investments these multibillion-dollar funds own, they only provide a very limited snapshot into the opaque world of hedge funds. The 13F reports also only detail U.S. equity positions, so they exclude international equity holdings, credit holdings, cash and derivatives.

A great example is

Seth Klarman (Trades, Portfolio)'s Baupost Group. According to this hedge fund's latest 13F report, the firm appears to have owned just under $11 billion worth of stock at the end of December. That's not true. We know Baupost manages more than $30 billion overall, but there's no publicly available detailed list of the group's investments.

This shows the perils of investing based on hedge fund reports and letters. Outsiders do not have all the information, and investing based on limited information is a fast way to lose money.

All in all, it might make sense to follow hedge funds considering their reputation for making money, but this industry is incredibly opaque. Following hedge funds is fine, but investors need to be aware of the risks.

Disclosure: The author owns no stocks mentioned.

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