At Arm's Length - Financial Commentary about Money, Investing, and How It Affects the Average Investor

At Arm's Length: 05.17.05

Hiding in the Hedges

Last week's rumored problems in hedge funds sent the markets reeling which caught many individual investors somewhat flat-footed. In the short span of five years, hedge funds have made inroads in the market and the result of their participation is creating more volatility and quite frankly, mayhem.

The news was based on a rumor that hedge fund managers, an unusually well compensated bunch, scrambling to cover short calls, a method of borrowing stock from brokers in anticipation of the price falling. There is normally very little problem with the strategy, one that provides the industry with trading flexibility that mutual fund managers eyeball with envy. In fact, it was just that type of freewheeling, try-anything-to-make-a-buck job that lured many fund managers to that sort of unstructured freedom and the rich payday working that for exclusive clients provides.

Everything was fine until those rich clients decided that enough was enough and began redemptions. Unlike mutual funds who sell stock when there are investors who seek to take flight for whatever reason, the redemptions or the potential of them sent shudders through the markets. The problem lies with the much smaller pool of investors who have much larger stakes. This type of investing can create havoc especially when the decision to sell is widespread. Wall Street worried that the redemptions would be large enough that the largely unregulated group would begin selling positions throughout the marketplace and do so heavily.

That potential and sudden selling has been weighing on the market. Many of the economic reports aside, there was a time when the mutual fund industry was the barometer for the market. Analyst charted both the inflows (when purchases were made) and outflows (when investors removed money) as indicators of market sentiment. The problem that now underlies this indicator is the current unpredictability of the participation of hedge funds.

This balance of available cash, some coming, some going, was achieved as hedge funds were counted on to replace exiting investors by purchasing the opportunity.

While mutual fund inflows have remained positive, with the week ending 5.11 showing $4.4 billion in cash headed towards these investments, the majority of that money found its way to ETFs instead of traditional funds.

This influx of cash has been from largely institutional sources and not coincidentally, directed at the more liquid exchange traded fund. These funds allow investors, in this case hedge funds, the opportunity to direct cash to specific sectors providing what would appear to be a glimpse of market sentiment. It is widely believed that changes in investment objectives, easily tracked by following fund flows has provided some insight in how the markets will move.

According to AMGData, "the nature of the flow change or sentiment shift is as important to understand as the relative direction and size of the change". AMG began providing additional data about these trends in the hopes that specific inflow or outflows would provide a better look at the overall market while uncovering specific moves. This information was previously lumped into broad range reporting by the Investment Company Institute, the industry's trade association.

But this sentiment does not uncover the participation of hedge funds. Taking a look at these types of funds and the strategies that govern them come with a long disclaimer, much lengthier than the mutual fund mantra of "past performance is not an indication of future results".

Hedge funds are not for the faint of heart, although judging from last week's movement that was based on the possibility that Goldman Sacks was calling due an extensive short position by raising margin requirements, fearing widespread panic some investors became very worried.

It is debatable however whether these types of funds are solely to blame. Loose money created by the Federal Reserve, lax margin rates and the generally unregulated nature of the investment all play important roles in why these funds are suddenly in the news.

Once the markets find a trading range, one that is nonplussed by good news about earnings, jobs, oil, and housing starts and barely reactive on bad news about inflation, growth, and the chance that those rates might continue to tighten further in the coming months, all will be seemingly well. At least the short lived rallies will not be as frequent at the end of the trading day.

What hedge funds represent now that they did not previously is their reflection of Alan Greenspan. Hedge funds have taken full advantage of the Fed chief's mishandling of the economy and all of the major markets will feel the pain. While Greenspan certainly is not Paul Volker, recent comments in the Washington Post offer a more dire view of the soft patch the economy is sometimes referred to languishing in. He wrote:

Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it.

The players in this market are wide in variety and short on patience. And for the average investor, the best place to be is on the sidelines watching the whole thing implode in a fiery show of inflated prices, slowing growth, and of course, panicky hedge funds.

The previous week's articles.

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