Some Things I Suspect About Hedge Funds

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By RodgerRafter
April 1, 2005

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Hedge Fund Basics
You don't hear much about how hedge funds work in the mainstream financial press because most of them like to keep their dealings secret. The hedge fund industry has grown to over $1 Trillion in assets under management and has a major impact on the markets on a daily basis. Digging up information about them can be difficult, but I think it is important for all of us to try and understand what their impact is. Here are some basic things I've heard and discovered in trying to learn more about hedge funds:

-Hedge funds manage the assets of rich people, pension plans and other types of institutional investors.
-Their fee structure usually involves taking a 20% cut of profits with no liability for losses, which rewards hedge fund managers for taking on high levels of risk.
-They tend to be very highly leveraged, some borrowing billions of dollars from major banks to boost their investment capital many times over.
-A wide range of strategies are employed by different hedge fund managers, some very mathematical in nature, and others very manipulative.
-Hedge funds can trade just about anything tradable in the financial markets.
-There is little meaningful regulation of hedge funds, but at least they file their stock holdings with the SEC quarterly.
-Many of them are incorporated in the Caribbean, even though they operate in the US.

A Case in Point
I recently started digging into SAC Capital Advisors, a hugely successful hedge fund that is incorporated in Anguilla, British West Indies, but does its trading from offices in Connecticut. This fund is famous for outperforming the market, and recently took a large position in a stock I've been shorting, so naturally I wanted to learn more about how they work. I found an interesting 2-year old article from BusinessWeek via a Google search on the company's founder, Stephen A. Cohen.

Based on the article (READ IT NOW) it appears that SAC makes its money in two major ways:

Trading off of inside information.
Manipulating share prices to generate trading opportunities.

From digging into SAC's 13G filings (which they have to file when they acquire more than 5% of a company) I found that they mostly invest in thinly-traded, money-losing, small cap stocks and smallish pharmaceutical and biotech companies. The small cap stocks are perfect for price manipulation, while inside information goes an extremely long way with the pharmaceuticals because their prices vary greatly based on drug trial results.

I found that SAC managed hedge funds rarely invest in companies for long. They move in and out of large positions, always searching for quick trading profits, wreaking havoc on stock prices as they go. There also seems to be a hierarchy among the seven different funds I found mentioned in their 13G filings over the past 6 months. The smaller Sigma fund is supposedly where Cohen puts most of his own money, and it tends to have money in larger stocks. Sigma has about $20,000,000 invested in Google, for example, the vast majority invested after GOOG hit $200. The much larger SAC Capital Associates fund has far more holdings, and is likely the source of funds where most of the SAC traders described in the article try to earn their pay (and keep their jobs).

The Big Picture
I've heard a lot of things about hedge funds from the Profs. at Minyanville, both in their articles and via email exchanges, and putting it all together in my paranoid mind, I come up with this general idea of how hedge funds fit into the overall Wall Street picture:

-Hedge funds generate huge profits for the big investment bankers by borrowing large amounts of money (and paying interest, of course) and by paying commissions on trades and to borrow shares for shorting, among other things.
-Many hedge funds operate in a secretive world of shady dealings, legally separated from the big banks, doing the devious things the banks can only dream of doing, and passing a portion of profits from their dirty deeds back to the banks.
-Less influential hedge funds are herded around like cattle by their big banker bosses in order to do the bankers dirty work in moving markets.
-The hedge funds absorb tremendous, unregulated levels of risk, with the fund shareholders acting as the first line of defense for the banks.
-Many banks are severely exposed at the next level of risk if big hedge funds blow up, like Long Term Capital did, and default on the debt owed to the banks. This is a very real systemic risk because the banks can't keep close enough watch on how the hedge funds are doing and because high levels of risk are a hedge fund manager's ticket to riches.

With over $1 Trillion in play every day, hedge fund managers actually control very large portions of the market:
-I believe that volatility has been steadily sucked out of the market over the past 5 years, as certain hedge funds that profit by reducing volatility have been growing in size and influence.
-I believe that many stocks have been manipulated to send false TA signals so that traders at funds like SAC can generate big trading profits and keep their ridiculously high paying jobs.
-I believe that the action of large hedge funds greatly contributed to Greenspan's conundrum of falling long term rates and other high yield interest rates.
-I believe that many hedge funds actively prop up or boost the prices of their holdings of individual stocks and bonds, thereby boosting the fees they collect from fund shareholders (often pension plans).
-I believe that short selling hedge funds have likewise driven down certain other stocks more rapidly than they would otherwise have fallen.
-I believe that hedge funds are behind an increasing number of mergers and buyouts for a wide range of dishonest reasons.

A Very Bad 1st Quarter
Taking a look at some of the most common hedging strategies, I find that most of them did very poorly this quarter:

-In January, Caribbean Banking Centers (i.e. mostly US based hedge funds) boosted their holdings of US treasuries by $23 Billion. That was just in time to get creamed by rising interest rates. (Widely ignored but important side note: In January, Japan, China, Korea, Taiwan decreased treasury holdings by a combined $10.4 Billion.)
-The stock market as a whole has done poorly in the 1st quarter, and the highly leveraged hedge fund industry is net long by a wide margin.
-A great many hedge funds are short the dollar, and the dollar actually rose a little against many currencies in Q1.
-Short term interest rates continued to rise, putting ever more pressure on carry traders who didn't think the Fed would go this far this fast.

A significant number of hedge funds fail in any given quarter, but the general public never notices. I'm guessing that this latest quarter will bring about the demise of a record number of hedge funds, given the growth in the industry and the way that many of the major hedging strategies fell flat. Will it be enough for the rest of us to notice? Time will tell. One important thing to understand about leverage is that it causes forced selling. The steep spike in interest rates was probably influenced to a degree by some bond fund managers being forced to sell. The forced selling hasn't hit stocks yet, as the decline has been very much controlled. I suspect few people around here remember what a 5% down day on the Nasdaq is like, much less a 10% down day, but before 2003, there were quite a few big sell offs like that.

I still hold the view that eventually the system will break down in a very ugly way. The more hedge funds try to control and manipulate the market, the more pressure will be released when it finally blows up. Right now I think that the Fed is concentrating on breaking the backs of the mortgage lenders, who they largely blame for America's current over-consumption, and may actually be missing the significance a hedge fund meltdown. In so doing, the Fed may find that it first brings down huge portions of the hedge fund industry and causes a major crisis among major bankers who've overextended themselves by loaning the hedge funds all they can handle. The Fed may or may not know what it is doing in this regard, but either way it doesn't have much flexibility. In my book, the slowing economy is still on a collision course with rising inflation, and the global effort to prop up the dollar will only last so long. I expect that the next big plunge in the dollar will likely mean both an increase in the rate of inflation and accelerated job losses. This is the inevitable effect of the global rebalancing that is underway. Whether a hedge fund industry crisis becomes front page news in the coming weeks or the coming years, I think that there is simply no way to unwind all the leveraged positions that have helped create the global imbalances in the first place.

If anyone would like to help me dig deeper into the filings of SAC and other hedge funds, email me and I'll add you to my "Global Rebalancing" Yahoo group -

Comments about this post and links to more information about hedge funds are appreciated.

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