August 12, 2007

And in Other News, The Sun Rose in the East

THE SUNDAY TELEGRAPH'S HEADLINE for its latest story on the turmoil roiling the financial markets gave me a good chuckle: "Hedge fund panic was behind global stock markets collapse." Gee, you don't say. The hedge funds have been controlling the day-to-day market flows for God knows how long now and as such the news they were behind the latest rout isn't a surprise -- especially considering the BNP Paribas news was what kicked off this week's carnage.

Still, despite the headline, and some real bonehead comments within the story left unchallenged, there's some good information in The Sunday Telegraph's article. Apparently, the so-called "quantitative funds" -- those that use sophisticated computer programs to crunch out returns -- have really been getting whipsawed in this latest debacle. As their Wall Street bankers have been upping their margin requirements, a lot of quants have been been forced to sell their positions at a loss. This led one anonymous banker to tell the paper:

The increased payments forced hedge funds to sell assets to cover their losses. One London banker said both Thursday and Friday were characterised by remarkably light but very volatile trading in London with those who didn't have to sell staying at home while those who were forced to sell were badly punished.

"This is a one-in-a-100-year event in which there are extremely unusual correlations that no one prepared for," warned one banker. "We are in a situation where everyone is very scared."

Well, I can't deny that folks didn't prepare, but what a shocking statement -- a one-in-a-100-year event? Let's see, that puts us back to ... oh, 1907. Leaving aside the problems that went along with spectacular crashes such as those in 1929, 1973 and 1987 -- and, for that matter, 1907 -- it seems a bit much to make that statement when Long-Term Capital Management blew up just ten years ago. LTCM was perhaps one of the best quant funds out there before things all went to hell.

Still, there's no denying that many hedge funds are going through a world of pain right now, and the paper has interesting news on this:

Financial stability was further shaken as hedge funds' losses mounted, compounding fears that some funds could collapse. Goldman Sachs's Global Alpha fund, the US fund AQR and New York-based Tykhe Capital were rumoured to be in particular trouble, although this could not be confirmed.

Many so-called quantitative funds with supposedly low-risk strategies involving investment in both debt and equities were particularly hard hit because weeks of turmoil in the credit markets made it impossible for them to sell debt, forcing them to sell more stable equity assets at a loss.

"In the last week people have had to meet margin calls by selling equity positions. The quant strats [quantitative funds] have been hit hardest and it's become a bit of a perfect storm. Prime brokerages are increasing margin requirements so you have a self--fulfilling prophecy and spiral down," said one senior banker.

"The black boxes [funds' computerised investment strategies] are all similar. They are getting completely crushed," added another.

It has also emerged that many funds had invested in the same companies, causing prices in otherwise unconnected companies to fall dramatically.

Because hedge funds borrow much of the money they invest from banks, the concern is that contagion could spiral again when the markets reopen.

Just for the record, I'm cool with contagion right now. I've reached the acceptance phase with contagion. This is because of one statement in the story which was thrown in almost as an afterthought, but that I think is the most important of any of them: "It has also emerged that many funds had invested in the same companies, causing prices in otherwise unconnected companies to fall dramatically."

It stands to reason those companies are now more attractive buys than they were just a few weeks ago and may become even more attractive in future. Clever investors, as a result, may well make a nice profit when all is said and done. Dan Roberts, The Sunday Telegraph's business editor, has written a good story on buying low that readers may find interesting.

One potential outcome of this whole mess, I think, is that we may see a shift away from badly-performing alternative investments into equities, provided those equities are seen as relatively cheap. Alternative investments, of course, are no deal in themselves; and to be perfectly blunt, they're the upscale financial equivalent of backing a pool hustler. You're staking the hustler to beat some sucker and in return the hustler gets a cut of the win; and hedge funds, with their 20 percent shares of the profit and their hefty management fees, work the same way.

One can expect that as hedge funds continue to fail -- here's a nice site, the Hedge Fund Implode-O-Meter, that's tracking them -- investors, even at funds that are doing well, will seek to redeem their funds just to ensure they won't get caught up in the turmoil. Those outflows will turn into piles of cash, but that cash will eventually have to go somewhere, and what better place for that money than the equity markets?

On a final note, I would note with all due cynicism the story's last paragraph, in which our correspondents note some potential political fallout from the mess:

Gavyn Davies, Gordon Brown's former economic adviser, warned yesterday that central bankers around the world would need to address serious deficiencies in the regulatory system once the crisis had blown over. Meanwhile the Financial Services Authority began to audit London banks to assess their exposure to the US sub-prime mortgage crisis and to highly leveraged corpor-ate loans following a similar move by the US Securities & Exchange Commission.

Heh. I wish Mr Davies luck in convincing others of that. There is nothing the central bankers will be able to do to regulate hedge funds. If the industrialized nations do try to impose regulations, the hedge funds will simply change their own internal rules and regulations accordingly to avoid them. If that doesn't work, they'll simply go off-shore to jurisdictions where there are no regulations and work from there. Capital and people can easily move across borders, and when all is said and done the regulators won't be able to overturn two axioms of modern financial life: a fool and his money are soon parted, and let the buyer beware.


IMPORTANT DISCLAIMER: Nothing in the above post is intended as financial advice. Always consult with a certified professional before making investment decisions. People can and do lose money -- a shocking amount of money -- on the financial markets and this should be kept in mind when investing.

Posted by Benjamin Kepple at August 12, 2007 12:46 AM | TrackBack
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