Kass: Hedgies Get Their Comeuppance - TheStreet

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)."

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In 2007, I

warned

about the consequences and the volatility that would follow the unwind and disintermediation of the hedge fund industry.

In January 2008, in my

surprises list

for 2008, I further discussed the liquidation scenario that is now ever-present:

17. The hedge fund community (especially of a quant kind) is disintermediated in 2008. Outflows accelerate, abetting an already conspicuous trend of rising volatility in a market that behaves more like a commodity than ever.-- Doug Kass (January 5, 2008)

Finally, yesterday I discussed the same in the

Wall Street Journal

and on

RealMoney Silver

.

The Dukes traded in orange juice; the hedge funds had an overzealous love affair for materials/energy stocks and commodities. Both took their markets higher until the music stopped (for the movie's orange market, 25 years ago; for stocks, several months ago).

Over the last few days, the panic in the hedge fund industry has become as thick as the fog rising from Shinneock Bay in the Hamptons this morning. Fear of rising losses and redemptions (especially of a fund of fund kind) has many opportunistic hedge funds sitting on their hands in a buyers strike as those that are levered are being forced to sell.

What we are now experiencing is not only a flight to quality (into Treasuries) but a flight period -- that is, an unwind out of stocks, out of the carry trade, out of commodities, etc. -- and for many investors/traders, they are out of luck.

As I

suggested

(albeit prematurely) yesterday, this is the sort of capitulation that

always

marks a market bottom.

As it is said, it is always darkest before the dawn, as it was for bank stocks on July 14, 2008.

I suspect that the smart and liquid investors, like

Berkshire Hathaway's

(BRK.A) - Get Report

Warren Buffett, though not yet visible, are likely committing serious monies on the other side of this week's liquidations or are getting their ducks in a row to buy in order to capitalize on Mr. Market's sale. They will be greedy when others are fearful, and, in the fullness of time, they will likely record outsized gains out of today's carnage.

But for now, as the Duke brother screamed, "Where's Wilson (the hedge funds)?"

They are selling Mortimer.

Doug Kass writes daily for

RealMoney Silver

, a premium bundle service from TheStreet.com. For a free trial to

RealMoney Silver

and exclusive access to Mr. Kass' daily trading diary, please click here.

At the time of publication, Kass and/or his funds were long Berkshire Hathaway, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.