Critical Lessons for Investors From the Archegos Collapse

Do you want to borrow and invest in the stock market? Are you looking to trade in stocks rather than invest for the long run? You may consider these critical lessons for investors from the Archegos collapse before trading in the stock market. Archegos Capital Management is a New York-based family investment vehicle owned by Bill Hwang, a hedge fund legend Julian Robertson. You may find Archegos focusing on public stocks in the US, Europe, South Korea, China and Japan. It was estimated to have managed around $10 billion of its own money.

Bill Hwang was the founder of Tiger Asia, one of the biggest Asia-focused hedge funds, in 2001. However, the firm pleaded guilty to criminal fraud charges in 2012 for profiting from securities trades using inside information from large investment banks. Bill Hwang converted Tiger Asia into his family office and renamed it Archegos. You have Archegos Capital Management at the centre of a storm with the huge fire sale of stocks worth more than $20 billion last month. It has led to the wiping out of billions of dollars from US and Chinese stocks. What are the critical lessons for investors from the Archegos collapse?

What caused the Archegos collapse?

You must understand the term ‘leverage’ before you focus on the Archegos collapse. In simple terms, leverage means using borrowed money to maximise the potential return from an investment. You will find many traders in the stock market using leverage to increase the return from trading in stocks. 

Leverage is a facility that helps you increase your trading position beyond your cash balance alone as the broker provides borrowed funds. You have to make a deposit called the margin, which increases exposure to an underlying asset. In simple terms, you put down a fraction of your trade’s total value and your broker loans you the rest of the amount. However, leveraging or using borrowed funds to trade in the stock market can amplify both your profits and losses. 

You could lay the blame for the Archegos crisis at the doorstep of a financial derivative instrument called a total return swap. It is a contract that permits a user to take on the profits and losses of a stock portfolio or any other asset in exchange for a fee. You have one of the parties making payments depending on a set rate, and the counterparty also making payments based on the return from an underlying asset. For instance, if the underlying asset is a basket of stocks, payments are made depending on the income (share dividends) and capital gains (appreciation in the share price). 

Archegos used total return swaps to borrow money from top investment banks and made them purchase a basket of stocks. It paid banks a pre-decided fixed fee at uniform intervals and the interest cost on the borrowed funds. In return, you would find the investment banks paying Archegos the capital gains on the stock portfolio and dividends at pre-defined intervals. 

You would find top investment banks such as Nomura, Credit Suisse, and others buying shares on behalf of Archegos in return for a lucrative fee. Moreover, banks agreed to pay Archegos the capital appreciation from shares and dividends if it actually owned the shares. For instance, if the share prices went up or dividends were paid, you have the investment banks paying a return to Archegos. However, if the share prices crashed (investment failed), Archegos would have to pay the investment banks.

Archegos had total return swap agreements with many investment banks on the same set of stocks. However, the investment banks were not aware of this. It helped Archegos borrow heavily without having the requisite capital to fall back on. You have many investment banks attracted by such services’ hefty fees, turning a blind eye as Archegos amplified its buying power, sometimes by around eight times its capital. 

You have Archegos reaping massive profits as long as the stocks in the swap portfolio kept rising. However, Archegos faced problems after the share prices of ViacomCBS and other top stocks purchased on its behalf started falling. Investment banks made a margin call asking Archegos to put up additional collateral, which they could not do. The banks had no choice but to dump the stocks to minimise their losses leading to a further fall in the share prices.

The Archegos collapse could cost top investment banks billions of dollars in losses. Moreover, Bill Hwang, the owner of Archegos, lost around $8 billion in just 10 days. You would find the Archegos collapse sparking calls for the greater scrutiny of family offices that manage the wealth of rich individuals worldwide. The Securities and Exchange Commission or SEC, the securities regulator in the US, doesn’t regulate family offices. Moreover, SEBI, the capital market regulator in India, also doesn’t regulate India’s family offices. 

Critical lessons for investors from the Archegos collapse

• You must never borrow and invest in the stock market. For example, you may avail of a personal loan and invest in the stock market, hoping to make a quick profit. However, personal loans may charge you a high rate of interest. You will land in the debt trap if the stock markets crash.
• You have Warren Buffett, the legendary American investor and business tycoon calling derivatives as the financial weapons of mass destruction. It would be prudent if you stayed away from financial investments you don’t understand.
• You must understand the difference between trading and investing in the stock market. For example, many investors chase mid-cap and small-cap stocks and sector funds such as pharma funds to make quick money. You must put money in equity funds only if they match your investment objectives and risk tolerance.
• You may consider equity investments for the long term. It would help as stock markets are highly volatile in the short run. If you indulge in derivatives and short term trading, you are a trader and not an investor.
• It would help if you diversified your portfolio across asset classes such as equity, debt, gold and real estate based on financial goals and risk appetite. It would help if you reviewed your portfolio at least once every six months to make sure it matches your investment objectives.
• It would help if you avoided Copycat investing or tracking the investment moves of famous investors. However, the financial goals of super investors are different from ordinary investors. You also don’t have access to critical and in-depth information on companies.

You may avoid trading in stocks and focus on long term investments in equity funds if it matches your risk profile. However, it would help if you did not touch financial instruments you don’t fully understand. It will help if you don’t borrow and invest in stocks. The Archegos crisis has shown you that leverage can be highly destructive. Moreover, you must avoid concentrated investments if you are a beginner in the stock market. In a nutshell, invest in equity mutual funds for the long run rather than trade in shares for the short term. 

For any clarifications/feedback on the topic, please contact the writer at cleyon.dsouza@cleartax.in