May 6 Stock Market Plunge Caused By Hedge Fund Operation In Overland Park

This story is all over the internets this morning*. The "Flash Crash" of May 6 which caused the stock market to plunge 700 points in minutes was caused by the Overland Park based trading firm of Waddell and Reed.
From the Washington Times:

A trading firm's use of a computer sell order triggered the May 6 market plunge, which sent the Dow Jones industrial average plunging nearly 1,000 points in less than a half-hour, federal regulators said Friday.

The firm's trade, worth $4.1 billion, led to a chain of events the ended with market players swiftly pulling their money from stock market, the report said.

The Chicago Business website has this information about the plunge:

Waddell's selling algorithm had "no regard to price or time," the report said. That, coupled with the "aggressive" reaction by high-frequency traders hedging their positions, led to two separate "liquidity crises" -- one in the E-minis, the other among individual stocks.

Waddell's algorithm "responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already had sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs," the report said.

These arbitrageurs transferred the selling pressure to the stock market, sparking a "hot-potato" effect among high-frequency traders that rapidly passed the same positions back and forth.

Meanwhile, the report continued, the stock market began plunging as trading pauses kicked in at individual firms, as high-frequency traders became net sellers, and as market makers began routing "most, if not all," retail orders to the public markets -- a flood of unusual selling pressure that sucked up more dwindling liquidity.

Trying to understand how 'hedge funds' work is complicated. What is relatively easy to understand, however, is how fund managers make their big bucks: through performance and management feed:

A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit.

As with other investment funds, the management fee is calculated as a percentage of the fund's net asset value. Management fees typically range from 1% to 4% per annum, with 2% being the standard figure. Management fees are usually expressed as an annual percentage, but calculated and paid monthly or quarterly.

The business models of most hedge fund managers provide for the management fee to cover the operating costs of the manager, leaving the performance fee for employee bonuses. However, the management fees for large funds may form a significant part of the manager's profits. Management fees associated with hedge funds have been under much scrutiny, with several large public pension funds, notably CalPERS, calling on managers to reduce fees.

Performance fees (or "incentive fees") are one of the defining characteristics of hedge funds. The manager's performance fee is calculated as a percentage of the fund's profits, usually counting both realized and unrealized profits. By incentivising the manager to generate returns, performance fees are intended to align the interests of manager and investor more closely than flat fees do. In the business models of most managers, the performance fee is largely available for staff bonuses and so can be extremely lucrative for managers who perform well. Several publications publish annual estimates of the earnings of top hedge fund managers. Typically, hedge funds charge 20% of returns as a performance fee. However, the range is wide with highly regarded managers charging higher fees. For example Steven Cohen's SAC Capital Partners charges a 35-50% performance fee, while Jim Simons' Medallion Fund charged a 45% performance fee.

As the hedge fund remuneration structure is highly attractive it has been remarked that hedge funds are best viewed "... not as a unique asset class but as a unique ‘fee structure’.

Missouri's best known fund manager is retired billionaire Rex Sinquefield who personally has given over $10,000,000.00 to an advocacy group called, "Let Voters Decide" which is seeking to recall the earnings tax paid by Kansas City and St. Louis workers and corporations. From The Turner Report:

Let Voters Decide appears to be a somewhat misleading name.

Considering that he has already poured more than $10.6 million into the earnings tax issue, it appears retired billionaire Rex Sinquefield is planning to make the decision on his own.

Sinquefield passed the $10 million mark today when he contributed $3.9 million, which looks to be the largest amount donated in one chunk to any Missouri candidate or cause, according to Missouri Ethics Commission documents. Let Voters Decide, a Sinquefield initiative is pushing for repeal of earnings taxes in St. Louis and Kansas City.

And from Fired Up Missouri:

Yesterday, GOP financier Rex Sinquefield moved another $3,900,000 of his personal fortune into the Let Voters Decide committee, his committee to get Proposition A onto the ballot and passed in November.

Sinquefield's personal investment in the ballot initiative now exceeds $10.7 million.

* 1/19/2010 - $500,000.00
* 2/15/2010 - $500,000.00
* 4/1/2010 - $750,000.00
* 6/3/2010 - $2,534,000.00
* 6/16/2010 - $2,534,000.00
* 9/30/2010 - $3,900,000.00

The only other donations found in the Missouri Ethics Commission searchable database for the committee are $400 from Robert Poli of St. Louis earlier this year, and $5,001 donated yesterday by Travis Brown, a Sinquefield lobbyist.

As summarized by the Post-Dispatch, "If Proposition A wins statewide, voters in St. Louis and Kansas City would be required to hold an election every five years on whether to continue their city earnings tax. If Proposition A passes, the first such election would be in April 2011. Unless voters opted to continue the city earnings tax, it would be phased out over 10 years and could not be reimposed."

*From the New York Times, May 6:

As of about 6 p.m., all the officials knew was that there had been what one called “a huge, anomalous, unexplained surge in selling, it looks like in Chicago, at about 2:45.” The source remained unknown, but it had apparently set off algorithmic trading strategies, which in turn rippled across everything, pushing trading out of whack and feeding on itself — until it started to reverse.

Federal officials fielded rumors that the culprit was a single stock, a single institution or execution system, a $16 billion trade that should have been $16 million. But they did not know the truth.

I have a friend who is more conservative politically than I am liberal. While we are on different sides of the aisle on most issues, we share some common interests.

In one of our conversations he made a comment that he'll let me have the presidency, the Senate and the house, just let him control the money and he will rule over everyone.

He reminded me of Amschel Rothschild's famous quote: "Let me issue and control a Nation's money and I care not who makes its laws."

I think he's right.