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January 19, 2007
Hedge Funds: “Enhancing economic flexibility and resilience”?
The above quote, taken from Alan Greenspan, was uttered by a man hell-bent on allowing hedge fund horses to roam free. Well Mr. Greenspan, your erroneous contention that hedge funds are reserved for the wealthy (a ridiculous opinion given that funds of funds were already gaining traction in 2005), is about to be completely blown-up.
Fortress to Raise as Much as $634.3 Million in IPO ~ Bloomberg
News that Fortress Investment Group LLC plans to go public barely caught the media’s attention today. This is unfortunate considering that it could be one of the most important announcements this year. Why is it so important? A statement from Craig Asche, executive director of the CAIA Association, will suffice:
“Anybody who has thought about this opportunity will be pretty quick to act if the Fortress IPO is well-received.”
In other words, a landslide of hedge funds could be nearing a trading screen near you, and come earnings season this is what you may be reading: ‘Fortressed III reported $6.45/share in earnings last quarter (or negative $52/share GAAP), while Amaranthed Jr. lost $1.2 million per share and will be delisted tomorrow’. Exaggeration aside, that hedge funds could be about to infiltrate the US public markets is yet another sign that ‘excessive liquidity’ is creating a dangerous environment for the average investor. To be sure, who are the only investors that would really be interested in purchasing shares in Fortress and other hedge funds but currently can not do so? Small investors, that’s who…
A rather lengthy quote helps explain today’s craze for hedge funds and private equity.
“The search for yield is particularly manifest in the massive inflows of funds to private equity firms and hedge funds. These entities have been able to raise significant resources from investors who are apparently seeking above-average risk-adjusted rates of return, which, of course, can be achieved by only a minority of investors. To meet this demand, hedge fund managers are devising increasingly more complex trading strategies to exploit perceived arbitrage opportunities, which are judged--in many cases erroneously--to offer excess rates of return…
I have no doubt that many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return. For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns.
But continuing efforts to seek above-average returns could create risks for which compensation is inadequate. Significant numbers of trading strategies are already destined to prove disappointing, a point that recent data on the distribution of hedge fund returns seem to be confirming.
Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink, and many wealthy fund managers and investors could become less wealthy.”
Why are some worrywarts’ words noteworthy given that everyone will soon be able to buy publicly traded hedge funds, hedge fund ETFs, and I-Love Private Equity key-chains on Ebay? Because the above quote was made by Mr. Greenspan almost two years ago… (link)
Suffice to say, the mad rush of capital into hedge funds, which was already bordering on the ridiculous in 2005, almost tripled last year to $126.5 billion (Hedge Fund Research Inc.) Moreover, as many average investors swarmed into hedge funds, according to a survey the wealthiest started to leave, and funds underperformed. As more funds inevitably underperform what is to stop many managers from taking on more risk? You guessed it, nothing...
Déjà vu
In the late 1990s I marveled at the fact that mutual funds were expanding so rapidly that within a couple of years there would be more mutual funds than publicly traded companies in the US. With the 2000 bear market arriving that never actually happened, but it nonetheless still seems insane that with so many supposedly empowered investors that the US still needs more than 8,000 mutual funds today.
With the hedge fund count above 10,500 and still growing, the ‘marveling’ stage has left the building. In a world where the S&P 500 outperforms the inflated hedge fund average (in 2006) and ETFs can effectively group together seemingly any asset class imaginable, the argument that these vehicles are ‘Enhancing economic flexibility and resilience’ seems ludicrous…because it is.
Incidentally, the real danger is not the next hedge fund blow-up per se, but that a large chunk of the money moving into hedge funds over the last couple of years turns scared at once. Unlike the mutual fund pullout of 2002 – which simply crushed stocks - many hedge fund managers do not operate portfolios that will react kindly to unexpected redemptions. Rather, when the redemptions start portfolio de-leveraging can, and likely will, come to be seen as brutal exercise in chaos in the financial markets. The only questions are when will the redemptions start and just how freely will Greenspan’s horses be roaming when they do...
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