First, the recent history. At the end of October equity markets around the world began to rise. By late April things were getting a little crazy. The pros were putting money into exotic bonds and equities in places like Turkey, Russia and Brazil. Japanese retail investors, who hadn’t bought stocks for a decade, subscribed for a billion dollars of a new India Fund. By May 9 risky assets had posted big gains, with small New Era tech stocks and the raunchiest bourses in the emerging markets showing the fattest returns.
The next day, out of a clear blue sky, markets from New York to Timbuktu plunged. The emerging markets index plummeted 24 percent, but much worse declines were not uncommon: the leading media company in Turkey fell 70 percent in dollar terms. By late June prices had stabilized, but since then markets have been manic-depressive.
Why? Sure, we have a new Fed chairman who has yet to be tested, and the Middle East is a mess again. But the world economy is still just right–not too hot and not too cold. Instead, much of the volatility is attributable to the rise of hedge funds and the sociology of their investor base. It is generally agreed that hedge funds, which control a tiny fraction of total stock-market investment, probably account for about 40 percent of the trading on the New York Stock Exchange and perhaps even more in the less formal markets.
Hedge funds use substantial leverage, on the order of two to five times their capital base. They are hyperactive traders, with turnover of 500 to 1,000 percent. This means that their purchases and sales in a year amount to five to 10 times their capital, so the amount of money they are moving is vastly larger than their stated size suggests. They also charge much higher fees than investment-management firms–2 percent of assets and 20 percent of profits–which makes their investor base very sensitive to performance.
Aggravating this tenderness is the fact that 35 percent or so of their investor base is accounted for by funds of funds (FOFs). Even wealthy individuals and medium-size institutions do not have the resources to select and monitor esoteric hedge funds, so an FOF does all that by constructing a portfolio of hedge funds, for which it charges 1 percent of assets and 10 percent of profits (on top of the 2 and 20 charged by hedge funds). Furthermore, most FOFs are affiliated with a financial institution and offer leverage. Their pitch goes like this: “Our fund should return, after all fees, 6 to 8 percent a year. Not that exciting, you say? Give us a million dollars and we will loan you an additional $2 million. After paying interest, if our fund does 7 percent your return is going to be close to 20 percent.”
This arrangement is fine as long as the hedge funds are making money, but when they are struggling, the interest expense magnifies the heavy double-fee burden inherent in the FOF structure. Investors become sullen and mutinous. As a result, the FOFs are extremely intolerant of monthly and quarterly losses–“drawdowns,” in the lexicon of the business.
What happened in May was a chain reaction. The sequence goes like this: Suddenly, for whatever reason, markets stumble. The hedge funds begin to lose money, and their reflex reaction is to sell to reduce their risk–their net long exposure. This causes further weakness, and that weakness spurs further selling.
Today all of us hedge-funders are in an awkward position. We have lost most of our gains for the year. At all costs, we want to avoid losing more and slipping into a loss. On the other hand, if a big rally develops we’ve got to get back in the game because our clients in general, and the FOFs in particular, will go ballistic if we lag on the upside. Last week when markets began to rally, underinvested hedge funds scrambling to get into the action fueled the surge.
With total hedge-fund capital now at $1.5 trillion, a 10 percent change in net exposure would swing $150 billion, far in excess of any quarterly flow in or out of mutual funds, ever. My guess is that the U.S. economy is weakening, the Fed is finished raising rates, equity markets will rally and hedge funds will fall all over themselves raising their net exposure. I could be wrong. Either way, prepare your investment soul for volatility.
