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Thursday June 8, 2006 - 22:42:28 GMT
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What About A Collective LTCM?

Don't get me wrong I am a big fan of hedge funds and believe they have a crucial role to play in an efficient use of capital...they are the carrot and the stick for good and bad policies, performance and provide a system of checks and balances to asset markets and currencies.

But like most things in capital market theory, this is an optimization problem. Hedge funds are collectively too big for anywhere close to being able to perform the function they set out to achieve in portfolio theory. They are the Ipod of investments...everyone who is anyone has to have money with them from state teacher retirement funds, to central banks, to commercial banks to increasingly retail. The model was built on wealthy individuals who could use some risky uncorrelated investment to compensate for a portfolio of lower risk investments that under perform like in a bear market in stocks.

The number we hear most often is $1.0trln under management and over 8,000 registered in the US alone and a surge in new hedge funds in Europe and increasingly Asia. I suspect the total of assets under management is closer to $2.0trln than the oft stated $1trln. It may be even more. These flows in and out of asset markets are the 1000 pound gorilla, amplifying volatility and more and more momentum. Listening to all the reasons why copper, gold and yes oil should be trading at 2-3 times values of a few months ago becomes interesting to say the least. My personal favorite is the demand for gold jewelry from India. The people who say this by and large never gave India a minute of consideration until they did what everyone else did - bought gold.

However assets under management tell only part of the story. Add in leverage (up to 6 times) and supply. The banking system has rivers of credit on hand for hedge funds. Hedge funds are perhaps the single largest client base for many financial sell-side institutions on the transaction side and increasingly as destination for bank investment with some outright buying of hedge funds, creating in house hedge funds or plowing bank capital into hedge funds. Some are doubling down if not tripling down.

Then there is the issue of double counting (form of money creation?). Hedge fund A gets $100mln to manage, then sets up and internal fund of funds and allocates $10mln to a set of fund managers. The hedge fund still "manages" $100mln but in truth the total under management goes to $110mln.

Additionally there is a definitional problem with hedge funds. Many hedge funds are also deeply involved in VC, reinsurance, REIT and LBO businesses. This sector is an increasingly layered set of businesses that have less to do with exploiting imperfect information and market anomalies in cash and futures. In some instances it is the modern age version of turn of the century US businesses that ultimately became vertical monopolies.

Meanwhile the promise of uncorrelated investments and high returns has not lived up to its promise collectively in this sector in the last 5 years at least. Sure some have hit the ball out of the park and some continue to defy reversion to the mean. But so many have come up short. Why? I don't know for sure, but I think it is simply a scale question...too many and too much money to manage. What investment anomalies exploited so skillfully in the past by legendary and pioneer hedge fund managers have become open to pretty much anyone. Surely not anyone will be in the game for long, but the informational advantage of hedge funds from the mid-80's to the mid-90's has been commoditized. Everyone has access to the same information most of the time (clearly not all of the time) and hence there is great replication of trades. Add in leverage and mix of risk management, and markets that should be uncorrelated are correlated. The zero sum game has come home to roost. The winners get in early and out early (okay always true, but maybe ever so more true today than in 1990).

Theoretically, the hedge fund world is disproportionately large to generate the kinds of uncorrelated returns that make this sector a hedge against "normal" (non-leveraged) investments. Barriers for entry are nearly nonexistent...I know that is controversial but what other business sector in 20 years has gone from a handful of firms to perhaps 10,000 globally?

Regulators are surely hoping to prevent another LTCM from happening. But what if there is a collective LTCM problem in the making? What if for instance stocks fall 15% this week, gold drops 25% and EM currencies drop 15% and EM bonds sink 10%? Replicated trades and leverage could topple improved credit risk management from the banking sector. Yes banks no doubt can spot problems at one hedge fund, but what about a collection of hedge funds having the same set of problems at the same time?

What am I suggesting we take away from this? If the market moves toward a collective hedge fund problem, the fundamentals will matter less and less and structural risk aversion and position liquidation will drive markets. For the last three weeks the financial press would have one believing that every sneeze from Bernanke to Ahmedinejad explains each movement in asset prices and currencies. Hog wash. This is all about hedge funds unwinding the same handful of leveraged trades.

I am not suggesting this all has to end badly and with a massive round of wealth destruction. I am saying that this is a risk and a growing one that reflects an industry that is too big to live up to its promise. One observation I will make is that the super sizing of a high risk low allocation investment class works best in a world of predictability...monetary policy is crystal clear, inflation low and growth sound. But in an environment of unpredictability in monetary policy, growth and inflation, the sector is due for serious downsizing. Rising global interest rates has pinched the life source for this investment sector and arguably put in motion the collective reduction of risk.

From where I sit, yes not self-important...just my view, this skewed
allocation of capital by a bloated sector of the financial market remains largely invested and exposed to long equities, long commodities, long emerging markets and heavily exposed to credit (derivatives). More can come out but I don't know if it will. But as it does you have to like Treasuries on flight to quality (short-term, see c/a-related problems longer-term). But pretty soon a t-bill with a 5% handle will look awfully attractive if hedge funds continue to unwind trades and fall far short of stated investment objectives.

David Gilmore


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