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Hedge funds: News, views, or blues, try and find a fact
by Paul Wallis

The current information about global hedge funds is pretty vague. Some have taken serious hits, others are down a whopping 3-5% after the massacre on the stock and securities markets. Compared to 11% for the stock market itself and God only knows what for the securities markets, that’s not a lot.

Hedge funds are as much a culture as an industry group. They’re highly diverse, and they tend to reflect the style of their managers. Their market profile is based on very high returns, and a sort of mythos about being a clever investment methodology. They’re not regulated, and not liked by the more conventional investment establishment.

They’re actively loathed, however, for their ability to affect markets, and frequently accused of market manipulation. That’s a rather disingenuous accusation, given the ability of some traders to benchmark prices with their own methods. Hedge funds are undeniably opportunists, but for market insiders to suggest they’re operating any more or less ethically than anyone else is pretty absurd.

The hedge funds, however have a lot of capital, and they can create market situations, with the obvious effects in some cases being a sellers market across various investments. Oil futures were a case in point in 2007, where hedge funds lapped up futures. They’re also frequently cursed for short selling on the stock market, but they’re not exactly the only people on Earth who use that very effective hedge against the stock market’s inbuilt ability to incinerate investors with the odd swan dive.

The hatred of hedge funds is partly folklore. They’re investment vehicles, outside the mainstream. It’s taken nearly 20 years for them to get to their present status, and in that time, their performance has made the mainstream investment options look very ordinary. Many hedge fund investors are people who found their returns in the retail market pretty dismal.

Not many retail investors actually question their rates of return, and those that do soon find they’re investing in a cartel-like market where cheapskate returns are the golden rule. If you think about it, "8% or something" for a whole year is a pretty ridiculous return. Day traders can do that in a week, without even trying. The investment market monoliths effectively created their own competition, simply by making it clear that anyone who could get better returns for investors had nothing to beat.

As competition, hedge funds weren’t taken seriously until it was too late, hence the fear and loathing. The hedge fund operators are also largely ex-mainstream people. They know what’s wrong with retail investment, intimately. They were originally seen as mavericks, now they’re seen as a hyperactive, overachieving, part of the investment sector.

Hedge funds do come with risks. There’s no guarantee of capital, and if you lose, you lose. Hedge fund managers rely on profits, and if they don’t gain, they lose. Investors can lose everything, and the fund managers, if they get it wrong, can be severely punished, both in terms of capital and reputation.

So the present situation, in which hedge funds are showing their first significant losses ever, is worth a look. The financial press, which seems to like hedging its commentary, is reporting doom and gloom, successes, failures, and quite a lot of circumstantial evidence in all directions. But the stats are showing that although some hedge funds have been knocked around badly, the sector itself is only slightly bruised after the head-on with the subprimes.

Hedge funds invest across the entire spectrum, some specializing, but the derivatives market isn’t/wasn’t necessarily a natural choice for them. Derivatives aren’t by definition high yield. Mortgage securities, ironically, were touted as good secure investments. Being securities, they usually trade at increments which could bore a rock to death.

So the hedge funds, chasing good returns, might have been interested in mortgage securities when they first started to get attention and were selling well. The initial interest is the usual “stag” phase where a real market price is created. After that, securities find levels and trade around those levels. However- a security which moves a few bucks a month each way isn’t going to get you that 20% return in a hurry, if you’re a hedge fund. Unlike more conventional funds, particularly the index-linked funds, hedge funds don’t make money by watching the paint dry.

If the hedge funds weren’t over exposed to the subprimes, their losses would work out as being notably less than the market, which seems to be the case, with exceptions. Their other profits would also absorb quite a bit of the damage. So a net loss of 3-5% probably does indicate they got through without a lot of hair loss.

What’s happened in the meantime is that the investors have been bailing out of the markets. This is “duck and cover” at its least ambiguous. The last 18 months could have been written as aversion therapy for investors. The inflow to hedge funds has been drying up, to the extend of 75%, according to some estimates. The subprimes weren’t book values. They cost the whole investment market real money, and hedge funds don’t take IOUs.

Now, some true absurdity:

The financial media, in its infinite something or other, has taken this lack of inflow to mean the end of the hedge funds. Some hedge fund managers are getting out, because the returns in the present market aren’t working for them. That, too, is apparently an immediate indication of the collapse of the hedge funds and the return to savings accounts.

Others are reporting boom times for some funds, and are basically giving testimonials out of the goodness of their hearts. Still more sources are reporting that at least one South American government wants to ban hedge funds and short selling.

The lucky investor, receiving this information might want to consider a few things about this news:

1. If the hedge funds, which are top line performers in the markets, are doing so badly, what’s happening to the others?

2. The drying up of inflow into hedge funds may also reflect the loss of real capital in the broader investment market. That 75% volume could be an actual indicator, for once, of real figures in relation to the actual state of the market.

3. At least some money is still going into hedge funds, which is more than can be said for the stock market. Why?

One day financial sector news and commentaries will be written with more than “and now a word from our sponsor” as the motive.

But don’t hold your breath.

Published: Sep 3,2008 22:41
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