Do we need hedge funds?

The more we think about it, the less sure we become. What is actually the rationale for these funds? Do they serve, in their pursuit of private profit, a greater good, Adam Smith’s original defense of the market economy? Well, sometimes they do, sometimes they don’t. 

The useful function they perform, apart from providing a return for their customers, is sniffing out bad practices, and then selling short, supposedly keeping the share price in check and thereby saving people from greater losses once the bad practices become common knowledge.

However, this presupposes that these funds are better at sniffing out bad practices than others, and we fail to see why this should be the case. Agreed, rating agencies have performed badly, Stock analysts on average are too optimistic, but we know of a Dutch guy who has proprietary software for sniffing bad practices out by looking at a host of indicators.

That software gave (often very) early warnings on a host of seemingly healthy (and even admired) companies like Ahold. If one guy can do this, we’re sure others will be able to to something similar. Fund managers also have an incentive to check and double check, and provide a natural antidote for analyst average inherent optimism.

So, we are not even too sure about how much good they bring in their most beneficial functions (and whether these functions cannot be performed by other parties), there exist ample room for opportunistic, not to say predatory behaviour.

Here a quote from Jim Cramer:

  • Cramer said commodity stocks bear no relation to the actual health of the companies. In effect, companies that are doing well are seeing their stocks slammed in the stock market. That’s because these stocks are completely under the control of large hedge funds, some of whom are much larger than the companies they trade, he said.

And he should know, in a former live as hedge fund manager he was intimately familiar with these kind of strategies. Why do a whole lot of difficult research in sniffing out dangers in numerous companies while it is much easier to just pray on companies that are, because of their size, easily kept under control.

We have already produced a host of articles on how (often naked) short-selling can drive companies down. We are mystified why it has taken until now for serious proposals to regulate these hedge funds to emerge.

Another risk, now coming prominently to the forefront, is their use of leverage. Agreed, they’re not the only ones who use what can only be characterized as risky amounts of leverage, but We have seen in 1998 with Long Term Capital Management how leverage can bring funds in problem, and how these problems can spread rapidly through the system.

And we see it even more today. De-leveraging is perhaps the crisis most important mechanism, together with failing trust. Italian Finance minister Giulio Tremonti has actually proposed measures to ban hedge funds on the IMF meeting today.

Below is another article with the latest in hedge fund land. Like lions in a cage, they are turning upon themselves. One’s first reaction might be one of satisfaction, but remember, these funds have an oversized place in the financial landscape, trouble is likely to spread.

Hedge Funds Eat Their Own
Friday, October 10, 2008 2:30 PM
By: Gene Koprowski

  • A wave of redemptions is hitting hedge funds, and the surviving funds are adopting predatory strategies to profit from the unraveling of the positions of their rivals.
  • According to a report published in the Financial Times, hedge funds are engaging in increasingly cannibalistic activity in order to survive.
  • Since so many firms hold similar positions, selling by one in response to redemptions can have ripple effects, forcing other funds to sell.
  • More nimble hedge funds have sought to profit from the dynamic by taking short positions in securities known to be widely held by rivals.
  • The strategy of hedge fund managers during the bull market — mirroring the positions of others — has been reversed, Goldman Sachs analysts said in a research note. “Buying the most concentrated stocks … has been a poor strategy during the current bear market,” the analysts reported.
  • The recent news that Ospraie Management was shutting down its flagship fund encouraged predatory activity.
  • Hedge fund managers have been monitoring the positions held by Ospraie, readying themselves if other funds with the same positions are forced to liquidate their holdings.
  • The fund’s largest position was in XTO Energy, which dropped from $73.74 in June to $24.81 during trading today. That company was among the 20 widely held stocks by hedge funds, according to Goldman’s research note.
  • Funds are also watching Deutsche Bourse, due to its big position in shares held by Atticus, which told investors that its main hedge fund is down 25 percent so far this year.
  • In a note to financial journalists, Houman Shadab, a senior fellow at the Mercatus Center at George Mason University, said that, like other investors, hedge funds are looking for strategic buying opportunities in this turbulent climate.
  • “By standing willing to purchase the assets that other companies must unload, hedge funds make the unwinding process much smoother and prevent losses in their sector from spreading,” Shadab says.

It remains to be seen whether the latter effect will dominate the former..