Secrets Of Success: Hedge fund market in need of a trim

I cannot remember which of the many distinguished exponents of journalism it was who first coined the axiom that the answer to any newspaper headline that ended in a question mark was "no".

I cannot remember which of the many distinguished exponents of journalism it was who first coined the axiom that the answer to any newspaper headline that ended in a question mark was "no".

If that is the case (and a surprisingly high proportion of the time it is), this week's dramatic sounding headline in USA Today, "Could Hedge Funds Cause Market Meltdown?", should not cause investors too much concern.

However, I don't think it is right to be sanguine about the difficulties that are facing a number of hedge funds at the moment, even if some of the wilder rumours about fund closures and collapses that are doing the rounds are likely to prove wide of the mark.

As readers of this paper will know full well, what is currently happening in the hedge fund community is both entirely predictable and, in the long run, entirely healthy.

That is not to say the tough time that a number of hedge funds are having will not have an impact in the short term on the way that the financial markets behave. It is clear that it is already doing so. The harder question to answer is whether these problems are the symptoms or the cause of the current nervousness on the stock market.

Although both the regulatory regime for hedge funds and the internal risk controls inside funds are much improved on the past, there can be no certainty that we will never see another Long-Term Capital Management collapse. LTCM, you will remember, was the fund that blew up in 1998, sparking declines in stock markets around the developed world.

It is certainly the case that many in the business are convinced that there is at least one "big beast" in the hedge fund world that is now in trouble and may be hunted down and wiped out before the current market phase is over.

The facts are that the last two months have produced poor returns for most hedge funds. The CSFB/Tremont index, for example, suggests that the average hedge fund lost 1 per cent in April, with some sectors - notably convertible arbitrage and managed futures - losing more than 5 per cent of their value over the month.

Such losses are not in themselves a particularly impressive result for an asset class that bases much of its marketing on the fact that hedge funds are primarily interested in making absolute returns - that is, avoiding losses.

More worrying still for those in the business is that the trend is a continuation of a poor period of performance for hedge funds that dates back to at least the start of last year.

Of the six quarters since then, only one has been an out-and-out good period for hedge funds in general. This strongly suggests that the difficulties many funds are experiencing are more deep-seated than simply a run of bad luck or extenuating circumstances.

It is not hard to see what the underlying problem is, as it was clearly predictable in advance. It is the fact that too much money and too many hedge fund managers are now chasing the small pool of opportunity that helped to create the impressive-looking performance record of hedge funds over the past 10 years.

That track record, which appeared even better when set against the disastrous performance of the stock market in the 2000-2003 bear period, has in turn helped to produce an enormous flood of money into the sector.

Of course the extent of this overcapacity will vary from strategy to strategy (some sectors of the hedge fund universe continue to do well), but the fact remains that the only way to deal with it is for the number of funds to reduced by Darwinian competitive processes. One natural selection takes place, the survivors will be well placed.

However, many more hedge funds need to fail or go out of business before the industry in aggregate can hope to return to the sort of performance that first brought it to the fore.

There is a certain irony in the fact that the strategy that is doing best at the moment is "short bias" - funds that are primarily looking for opportunities to sell short, that is to bet on asset prices falling.

While this is the activity with which hedge funds have traditionally been associated, and the one that causes most controversy, in practice it is not anything like as prevalent as you would expect.

It also suggests that the activity that has got so many hedge funds into difficulty is essentially on the long, rather than the short, side. Other funds will be in difficulty simply because they have taken geared bets on a particular arbitrage trade that has gone wrong. They will be discovering that there are suddenly too many imitators for what they are doing.

In some cases, the ideas will have come from prime brokers who have been selling the same idea to all their hedge fund clients simultaneously. In others, the brokers will also have been selling the same idea to the trading desks of investment banks, which carry out much the same kind of trading as hedge funds, only with even bigger dollops of capital behind them.

In truth, it is very difficult for those outside the hedge fund business to know in detail what is going on, and which of the funds is suffering the most. In theory that should not matter to most of us, since sensible readers will, I am sure, have heeded all the warnings here and elsewhere about not investing in things you don't understand, especially when (in the case of hedge funds in particular) the rationale for investing in them is so frequently flawed.

It is, however, a matter of concern if the effects of a brutal market clear-out spill over into the way that the markets as a whole behave. In other words, if we end up with a repeat of the LTCM debacle, where the collapse of one large fund prompts a panic.

That could happen, for example, if poorly performing hedge funds have to start selling their positions merely in order to meet redemptions from their investors. That will only increase the losses of the funds affected and put renewed pressure on the liquidity of markets.

As it is, liquidity is drying up rapidly in the small cap area of the market, marking the end of the strong rally in that sector. Natural resource stocks have also been hit by one of the periodic pull-backs often experienced in that area, even in a new bull market for commodities.

We could be in for a few weeks when it is better to sit on the sidelines and wait for new and better opportunities to come along. And don't be too surprised is there is some more hedge fund blood on the floor before then.

jd@intelligent-investor.co.uk