Hedge Fund Bogeymen
Like water is the most universal solvent and type 'O' blood the universal donor, hedge funds are the financial industry's universal causal factor. If you can't figure out why something happened in the worldwide financial markets, you are safe saying it was 'hedge fund' related.
Hedge funds too have become the financial industry's boogeyman. When the semiconductor names go up hard, it's hedge funds that have been 'caught short' and are covering their positions. When oil tumbles, it's those hedge funds that have been 'too' long oil futures. When bond yields tumble, it is hedge funds that have been pressing their short bets. In fact, whenever there is an unusual move up or down in any negotiated financial instrument across the globe, invariably, we are told that it is the work of 'mysterious', 'secretive', 'largely unregulated', 'powerful' hedge funds. Before we tackle this convenient but ultimately false nostrum, let's get some facts straight first.
The worldwide mutual fund industry 5 years ago, excluding money market funds, was $9.3 trillion dollars in size and represented 46,000 different funds (ICI data). At the end of 2004, those numbers were $12.75 trillion and 51,363 funds, growing at 6.4% CAGR per year and 2.2% per year respectively.
The hedge fund industry? In 1995 the worldwide hedge fund industry was $480 billion in 6,200 funds (Van Hedge Fund Advisors data). At the end of 2004 those numbers had grown to $950 billion and 8,700 funds for a compound annual growth rate of 14.6% and 7% respectively.
So that makes the hedge fund industry something like 7% of the total assets under management. Let's put it another way that might give you some better perspective. The entire global hedge fund industry is 93% smaller than the mutual funds industry. But wait, can't hedge funds use leverage? And wouldn't such leverage cause them to have a bigger 'footprint' in the market? Reg T allows 2 to 1 leverage. And of course other derivative strategies could yield 10 to 1. So let's say, for argument's sake that something like 3 or 4 to 1 leverage is the average industry-wide (and this is a very aggressive assumption, it is likely to be much lower). That means that the $975b in hedge fund assets could represent a notional amount of $2.8 to $3.8 trillion. Still, hedge funds would be 18-23% of assets even under this most aggressive assumption.
What's my point? That hedge funds remain a small portion of the overall assets under management in the world. Yes, they are more active - they turn their portfolios over more frequently. But making the case that such active styles cause more volatility is an untenable conclusion: after all, during the time when hedge funds proliferated in the last 5 years, the VXO has declined to 8 year lows. One could hardly make the case that the more active investment strategies of hedge funds has caused increased volatility over the last few years.
So if hedge funds, via higher portfolio turnover, the use of leverage, and total assets under management, are not to blame for whatever is the latest unexplained move in bonds/currencies/stocks/commodities, then why do they get a bad rap?
There are many reasons this is so; some real, some imagined. The fact that the hedge fund industry doesn't have a lobbying group makes them a hard target for legislators - and if you don't think that the hedge fund industry won't be a massive target for regulation in any serious bear market, you haven't read your history books. That hedge funds only report their holdings and returns to their LPs makes them a target for the class warfare types who promulgate the idea that only entities that report their activities to government bodies have business ethics. Of course, intellectual laziness plays a role too; since a hedge fund's activities in any specific market cannot be disproved, proposing the idea that they are to 'blame' for this or that move in the markets is a safe journalistic statement.
There is also a psychological basis for this phenomenon. Psychologists call it projection bias: whereby a person projects their own undesirable thoughts, motivations, fears, etc. onto someone or something else. In this case, traders, investors, and media pundits are projecting their generalized fear of financial markets onto hedge funds. It's not the financial markets that we fear, it's hedge funds who "make" the markets do strange and distasteful things. Nietzsche (in Beyond Good and Evil) spoke to this with the following quote: "He who fights with monsters might take care lest he thereby become a monster. And if you gaze for long into an abyss, the abyss gazes also into you."
What made me bristle so much about this topic last night was a specific comment made by a sell-side strategist on PBS's Nightly Business Report. The strategist stated that hedge funds have made the stock market much more volatile in the last few years and that, as long as patient long term investors can live through that volatility, stocks will reward that patience. Apparently this particular strategist is either (1) unaware that volatilities in March made 8 year lows or (2) does not in fact know the definition of volatility. And to compound that original ignorance with the statement that hedge funds are in fact to blame for this non-existent volatility is an immediate disservice to the hedge fund business and a long term disservice to PBS viewers.
So the next time you hear that hedge funds are to blame for this or that movement in a market, take it with some sizable grains of salt. It's more likely that the commentator just didn't want to do her homework than it is that a hedge fund actually caused the move. And maybe too, she's just staring a bit too long into that abyss.
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