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Are Hedge Funds Heading Into the Perfect Storm?

You are going to be seeing and reading a lot more about hedge funds in the coming weeks and months. Two loosely related disturbed fronts are moving towards each other that may yet converge into the perfect storm.

The S&P 500 Index, the proxy for the US stock market, is up only 1.97 percent for the year, and down 1.7 percent for the quarter. The Lehman bond fund index is down 1.5 percent for the year. US stocks and bonds comprise the overwhelming majority of assets in individual investor portfolios.

That means very little or no growth for pension fund and 401(k) beneficiaries. For mutual fund and pension fund managers that means skinny or no performance bonuses. In a word, the pressure is on to somehow make a silk purse out of the sow’s ear of an underperforming US stock and bond market. That’s being done. New filings with the SEC indicate that a growing number of mutual funds will adopt hedging strategies like short selling and option investing to keep investors from leaving the herd and taking their assets with them.

On the other side of the disturbed front, the real hedge funds, unregulated private investment pools with a $trillion plus to toss around, are getting some unwanted heat from the regulators. Although they were held off by a recent DC Circuit Court ruling in favor of the hedge funds, the SEC is hot to regulate the hedge funds and is lobbying hard for Congress to give it the laws to do so.

Hedge funds are not mutual funds. They are not bound by any investment strategy description in a Prospectus. A hedge fund can implement any investment strategy that you as a private individual who got together with a few friends could do. Other than the always applicable laws against insider trader and outright fraud that leaves lots of room for creativity and financial maneuvers.

For example, in 1994 the former head of Solomon Brother bond department and two future Nobel Laureates in Economics got together and started Long Term Capital Management hedge fund with a few friends and billion in capital. Four years later LTCM was producing returns of 40% annually, and the hedge fund’s off balance sheet positions totaled a gargantuan .25 trillion. There probably weren’t a dozen people in the world who completely understood LTCM’s enormously complex strategy, and not many more than that who even knew enough to ask an intelligent question.

The Russian government’s bond default in 1998 created an international whirlpool of panic selling in other government’s bonds that threatened to sink LTCM and suck the entire international financial system down with it. The ultimate disaster was averted but you can bet that the memory of what “that hedge fund could have done” is very much alive in Washington DC and among the veterans of the financial press.

How does this fit together to create the perfect storm? Negative stock market returns demand a cause, identifiable culprits whose evil deeds have shaken investor confidence and robbed people of their retirement. It doesn’t matter if there is no actual connection if the story is compelling enough. Short selling hedge funds, fueled by the fallout from an insider trading scandal or two, make the perfect culprit. Hedge funds are not open to joe sixpack. The media and the public love villains.. The average hedge fund investor is a financial institution or a fabulously wealth individual. Who better?

About the Author: (c) 2006 by Peter Amaral. Peter is the creator of the website and author of several easy-reading ebooks on the exotic trading techniques of the legendary master traders like J.M. Hurst and W.D. Gann.

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