The Hedge Fund Bubble

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By RodgerRafter
November 1, 2005

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The hedge fund industry has grown rapidly in recent years, by one estimate going from an estimated $500 Billion in assets under management in 2001 to around $1.3 Trillion today. The rise in popularity of hedge funds is similar to that of technology stocks in the late 1990s and more recently the rise in popularity of real estate investment. In all three areas a speculative bubble formed as the initial success of savvy early investors attracted large numbers of new players into the field. The rush of new capital helped fuel additional success stories and eventually distorted asset prices far beyond reasonable levels. The fallout from the tech bubble was dramatic, with the Nasdaq 100 falling over 80% in less than 2 1/2 years and the national economy entering a recession. The fallout from deflating real estate and hedge fund bubbles hasn't been seen yet, but both bubbles already are showing serious signs of weakening and their combined bursting could have much greater impact than the bursting of the tech bubble.

Several factors are behind the rise in popularity and influence of hedge funds, As computer trading models improved through the 1980s and 1990s, talented hedge fund managers put them to use, generating profits in ways that had been overlooked by traditional investors. Interest rates had an especially deep decline from 2001 to 2003, meaning that leveraged hedging strategies had increasing chances of success. The business of underwriting had become less profitable for investment banks, but the business of trading with and financing the growing hedge fund industry had become much more profitable, so banks have been eager to help new hedge funds start up operations. Under-funded pension plans became a large source of funds late in the bubble's development, as plan managers sought high returns and were willing to take large risks with other people's federally insured money. As more investors and creditors piled into certain classes of hedge funds it created great short-term gains for most investors involved in the stampede.

The hedge fund bubble now seems to have passed its peak. has an index that attempts to measure the returns of the entire global hedge fund universe, as well as many strategy specific indices. According to their records, hedge funds returned an average of 13.39% in 2003 but returns averaged just 2.69% in 2004. As of 10/28/05, the year to date return was -0.97%, with October showing -2.36% on its own. All seven of HFR's main strategy indices were down for the most recent 4-week period, ranging from -0.29% to -3.55%. The decline in returns was predictable, given the state of the industry and the current economic climate. As more funds began competing for profits in the same areas, it became harder to generate profits on trades. As interest rates rose, the cost of using leverage increased. Key factors that fueled the rise of the hedge fund bubble have reversed course and so have hedge fund performance figures.

The financial markets have always been a place where fraud and dishonest dealings have played a role. As turning a profit has become more difficult, a significant minority of fund managers have resorted to less honorable means to try and show positive results in the short term while putting investor capital at risk in the long term. Unfortunately the unique fee structure of most hedge funds encourages short sighted performance goals. Some funds have evolved into "buyout" firms as they've guaranteed their own positive short-term results by buying up shares of stock until they have a controlling interest and then running the companies in short-sighted, cash-generating ways. Some funds have taken on much higher levels of risk by providing derivative "insurance" for other companies in the hope of generating bigger profits now. Some funds, like Bayou have resorted to simply lying about their performance. All of these tactics boost performance and fees up front, but can lead to spectacular meltdowns in the future.

Going forward, average hedge fund performance is likely to get much worse. Profitable strategies have become money-losing strategies, but money continues to pour into hedge funds, masking much of the damage that has already been done while creating the potential for even greater damage. When many types of hedge trades are unwound the funds that are last to exit will take the worst damage. The highly leveraged nature of many hedge funds means that small losses can be rapidly magnified and can force funds to liquidate their positions at a sizable loss.

It is hard to predict how much damage will be done as the hedge fund bubble deflates. The best case scenario for the financial markets would involve only minimal disruptions as hedge funds went through a slow cleansing process where bad funds were exposed and weeded out and good funds could once again earn solid returns for investors. Many investors would likely lose significant sums of money, but severe credit contraction and financial crises could be averted.

Unfortunately, the size, secretive nature, and the excesses of the financial services industry suggest that there won't be an easy way out of the problems that Wall Street and the hedge fund industry have created. The leverage created by lending new money to the hedge fund industry has caused asset inflation in almost every global asset class. Hedge funds playing the carry trade have been largely responsible for the tightening interest rate curve (Greenspan's conundrum) at a time when the US budget deficit and trade gap both seem to be soaring out of control. Already under great pressure, if those funds were to de-leverage rapidly, the result could be a dramatic rise in interest rates and serious shock waves sent through the housing, lending and retail segments.

Borrowing by hedge funds has contributed greatly to the expansion of the money supply. While M1 money supply contracted at a 2.2% rate from March to September and a 3.2% rate from June to September, but non-M2 components of M3 (mainly institutional money) has been expanding at a greater than 20% rate. Most of this surplus institutional money ends up in money market accounts that purchase US treasuries. It is possible that money creation by private banks, in order to finance hedge fund a wide range of investments and strategies, has indirectly funded a large portion of the US federal deficit. If so, the rapid deflation of the hedge fund bubble could cause a debt crisis for the US government.

The derivatives markets have seen a tremendous wave of growth as hedge funds have been major participants. Large, secretive, risk-seeking funds could quickly be wiped out once interest rates and equities markets returned to their usual, more volatile states. This could, leave many of their counter-parties with nothing to show for the hedging insurance they were counting on in a crisis, and throw large numbers of institutions into insolvency.

In the worst case scenario losses and failures would mount fast enough to result in a severe credit contraction. There would not be enough money in the financial markets to buy up the new treasuries the government wanted to issue. Interest rates would soar and government operations would shut down. The relative value of other assets would likely tumble as relative yields moved in tandem. Bad debt would lead to bank failures, and further tightening credit and the US government wouldn't be in position to bail them out. The derivatives market would see massive defaults and corporate balance sheets would be ravaged. Credit contraction and bank failures were a primary cause of the great depression in the 1930s and many depressions throughout history. Far too many citizens and legislators believe that the biggest threats to banking stability have been conquered, but they do not comprehend the magnitude of the new risks our financial system has created.

While we may or may not have reached a point where the worst-case scenario is possible, the continuing expansion of the hedge fund bubble increases the risk. Careful policy choices going forward could lead to a long slow deflation of the hedge fund bubble. However, those would be very difficult political choices to make. Our government is more likely to respond to industry pressure and continue on welcoming the short-term stimulus provided by the expansion of credit provided to the hedge fund and real estate industries. When the bubble will dramatically burst, how it will unfold, and how to avoid or even profit from the fallout remain the most challenging questions for the few investors, workers, leaders and politicians who are actually aware of the problem.

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