Hedge Fund Industry's Dirty Little Secret

Many are trying to understand or explain the synchronized decline in stocks, bonds and commodities in May. My explanation: It is the hedge fund industry's dirty little secret.

A long time ago, hedge funds were predicated on superior stock picking.

But in the intervening time, as hedge funds grew in size and quantity, it became increasingly difficult to differentiate investment performance by picking superior equities. As the pools of capital attracted to the hedge fund business multiplied geometrically, the industry morphed away from stock-picking and became a leveraged pool of capital. (Long-Term Capital begot others.)

After all, funding a longer-term asset yielding 5% with shorter-term liabilities costing 3% was a no-brainer, and so was funding a market rising exponentially, vis-a-vis cheap debt. The only question was how that spread would be multiplied by additional debt/leverage.

When the Federal Reserve and the world's central banks virtually gave away capital during the easing phase, taking interest rates to historically low levels, hedge funds (and capital) struggled to reach excess returns because many trades became crowded and risk premiums were taken out of emerging markets, junk bonds and even commodities.

The contraction in junk-bond yields to historically low levels (based on a long economic boom), the strength in emerging markets (with economic growth well above world-trendline levels) and the parabolic move in commodities (China and emerging-market demand was believed to be unending) were justified by commentators and analysts.

It was, after all, a new era yet again! But as investors learned in May, it created a false sense of security.

A vicious cycle was created as the appetite for risk turned into its own bubble. Generally speaking, investors (especially of the fund-of-funds kind) cared little about how returns were generated. Rather, they focused solely on the level of the returns that were generated.

And hedge funds complied by stacking cheap debt upon their equity bases in all sorts of carry trades (funding longer-dated assets with shorter-term liabilities). Many hedge funds even stretched reason by selling tons of volatility -- after volatility had fallen to record low levels.

Then, almost overnight, return on capital (appetite for risk) was replaced by concerns regarding return of capital (risk aversion), as uncertainty relating to the Federal Reserve's actions, coupled with tightening around the world, created a panic in the hedge fund's crowded carry trade and the bubble was pricked.

Once the weakest investors starting selling -- at the margin -- similarly correlated asset classes began to drop. It is noteworthy that the May panic was not accompanied by any fundamental change or, as in the past, a financial crisis, but by the perception of a change in liquidity.

Many (myself included) have cautioned that the growth and size of the hedge fund industry represents a significant bubble-like market risk.

I have repeatedly written that bubbles are almost always based on the same set of conditions:

1. Debt is plentiful.
2. Debt is cheap.
3. The egregious use of leverage becomes commonplace and accepted.
4. A new and growing asset class raises asset prices.

The above circumstances led to the Internet stock bubble in the late 1990s, to the real-estate bubble in 2003-2005 -- and, as we shall soon find out -- the bubble in hedge funds (and their appetite for risk).

I would now add the explosion in hedge funds, and the risks to their disintermediation, to my secular market concerns.

Caveat emptor.

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