Kass: Hedgies Get Their Comeuppance

This blog post originally appeared on RealMoney Silver on Sept. 5 at 8:16 a.m. EDT.

Like the Dukes who tried to corner the market in frozen concentrated orange juice in the film Trading Places, the hedge fund community is getting its comeuppance now.

For now, as in that fictional 1983 when the Secretary of Agriculture gave the pronouncement in Trading Places that the cold winter apparently is not affecting the orange crop, our commodity and stock markets, too, are in disarray and in liquidation mode.

Today, as equities and commodities slide, the risk managers have taken over from the portfolio managers. And those risk managers are selling posthaste regardless of a sense of value, the relationship of stocks to interest rates, etc. -- just as the movie's orange traders did 25 years ago.

I have long thought that the most dominant investors in the land -- hedge funds, many of which have taken abnormal risk in producing normal returns over the past several years -- would face the liquidity event we are now experiencing. And I remain of the view that a renewed level of instability in the levered (and often uninformed) fund of funds community is exacerbating liquidations.

All the way back in 2006, I cautioned that the hedge fund industry's dirty little secret was the excessive use of capital, which displaced old-fashioned stock picking as a means of generating excess returns, and that the unnatural growth in hedge funds was sowing the seeds of its own destruction. Accompanying this were the risks to their disintermediation and an eventual market selloff. While this became a growing secular market concern to me two and a half years ago, its timing was uncertain.

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.

-- Doug Kass (June 1, 2006)

Since the beginning of the decade (and possibly earlier), we have witnessed the morphing of the hedge fund industry into a dangerously levered capital pool. As Randolph Duke reminded us in Trading Places, they took a "perfectly useless psychopath like Valentine, and turned him into a successful executive. And during the same time, we turned an honest, hard-working man (Winthorpe) into a violently, deranged, would-be killer! (laughs)."