Why Are Hedge Funds Getting A Bad Rap?

  • May 23, 2005
  • Peter Navarro

Navarro’s Broad Market Outlook: CPI to the
Rescue

Score one for the Rally
Monkeys as the markets got a big lift last week.  If you want a reason for the
rhyme, look to the PPI-CPI news. 

While the PPI provided hints
of inflation, the CPI flat out found nary a clue.  The bullish view is that low
inflation means a restrained Fed.  But really, if the PPI is inching up and the
CPI isn’t, doesn’t that suggest some type of squeeze on corporate profits that
over the long run can’t be bullish.  And speaking of squeezes, consumers are
certainly grumpy, squeezed as they are by high oil and gas prices. 

Still, it’s pretty clear that
Mr. Market frankly doesn’t give a damm about longer run issues — at least for
now.

 


Market Movers of the Week:  GDP Me……

            New and existing
home sales come out — always a source of volatility for the sector.  But the
biggie is going to come on Thursday when Q1 GDP will be revised.

            The betting is on a
strong upward revision from 3.1 to as high as 3.8.  Why?  New trade numbers have
come in showing more exports and fewer imports which adds to GDP growth.  
So…..if we get 3.8 or higher, the bulls should get a nice buck up.

 


Portfolio Musing: Short WYNN

            I conventioneered
last week in Vegas and parked myself at the new Wynn Resort.   A la the stock
picking method of Peter Lynch, I hereby speculate based on a rather sour
personal experience that WYNN will be an excellent short.

            This is a mediocre
hotel marketed as the crème de la crème and, after the euphoria of its open
fades, its room rates are going to plunge back to earth — somewhere below the
Venetian, Bellagio, and Mandalay Bay which it can’t hold a candle to and above
Treasure Island and New York, New York.  Here’s just a short list of some of its
flaws:

            A car entry that
can’t accommodate even half of the traffic flow, a claustrophobic rather than
grand entrance, big lines at the check-in because of slow computers and
inadequate staffing, a casino that looks no better than what the Indians provide
in California, relatively small and surprisingly noise rooms, a total inadequate
gym with a very expensive price, a pool with too few seats for the number of
guests, mediocre cuisine, a Dragone show that isn’t as good as several other of
the Dragone shows in town, a golf course that charges $500 to play and doesn’t
have a driving range, a TV that malfunctions, and last but hardly least for this
poor stock market junkie, no copies of Barron’s for sale in the news stand (as
of Sunday a.m.).

 

Hedging Your Bets With Matt Davio: The Latest
Boogeyman


FIRST IN TWO-PART SERIES:

Like water is the most universal solvent and type
‘O’ blood the universal donor, hedge funds have become the financial industry’s
universal causal factor. If you can’t figure out why something happened in the
worldwide financial markets, you are safe saying it was those ‘mysterious’,
‘secretive’, ‘largely unregulated’, ‘powerful’ hedge funds. 

For example, when the semiconductor names go up
hard, it’s hedge funds that have been ‘caught short’ and are covering their
positions. When oil tumbles, it’s those hedge funds that have been ‘too’ long
oil futures. When bond yields tumble, it is hedge funds that have been pressing
their short bets. 

Before we tackle this convenient but ultimately
false nostrum, let’s get some facts straight first. The worldwide mutual fund
industry 5 years ago, excluding money market funds, was $9.3 trillion dollars in
size and represented 46,000 different funds (ICI data). At the end of 2004,
those numbers were $12.75 trillion and 51,363 funds, growing at 6.4% CAGR per
year and 2.2% per year respectively.

As for the hedge fund industry, in 1995 the
worldwide hedge fund industry was $480 billion in 6,200 funds (Van Hedge Fund
Advisors data). At the end of 2004 those numbers had grown to $950 billion and
8,700 funds for a compound annual growth rate of 14.6% and 7% respectively.   In
other words, hedge funds as a whole are less than 1/10th the size of
mutual funds. 

But wait, can’t hedge funds use leverage? And
wouldn’t such leverage cause them to have a bigger ‘footprint’ in the market?

Well, Reg T does allow 2 to 1 leverage. And of
course other derivative strategies could yield 10 to 1. So let’s say, for
argument’s sake that something like 3 or 4 to 1 leverage is the average
industry-wide (and this is a very aggressive assumption, it is likely to be much
lower). That means that the $975b in hedge fund assets could represent a
notional amount of $2.8 to $3.8 trillion. Still, hedge funds would be less than
25% of assets even under this most aggressive assumption.

So what’s my point?  That hedge funds remain a
relatively small portion of the overall assets under management in the world.
Yes, they are more active and turn their portfolios over more frequently. But
making the case that such active styles causes more volatility is an untenable
conclusion.

Now here the most damming fact: During the time when
hedge funds have proliferated in the last 5 years, the VXO measure of volatility
has declined to 8-year lows. One could hardly make the case that the more active
investment strategies of hedge funds has caused increased volatility over
the last few years.

So if hedge funds, via higher portfolio turnover,
the use of leverage, and total assets under management, are not to blame for
whatever the latest unexplained move in bonds/currencies/stocks/commodities, why
do they get a bad rap?   

For starters, the hedge fund industry doesn’t have a
lobbying group.  That makes them an easy target for legislators – and if you
don’t think that the hedge fund industry won’t be a massive target for
regulation in any serious bear market, you haven’t read your history books.

Perhaps more importantly, there appears to be a
psychological basis for hedge fund bashing.  Psychologists call it “projection
bias.”  This happens when a person projects their own undesirable thoughts,
motivations, fears, etc. onto someone or something else.

In this case, traders, investors, and media pundits
are projecting their generalized fear of financial markets onto hedge funds.
It’s not the financial markets that we fear, it’s really the hedge funds who
“make” the markets do strange and distasteful things.  And of course, all those
mutual fund managers that get outperformed by hedge funds have more than a
little bit of fear and hate too.

My last take on this subject relates to a specific
comment made by a sell-side strategist on PBS’s Nightly Business Report. The
strategist stated that hedge funds have made the stock market much more volatile
in the last few years and that, as long as patient long term investors can live
through that volatility, stocks will reward that patience.


Apparently this particular strategist is either (1) unaware that
volatilities in March of this year made 8-year lows or (2) does not in fact know
the definition of volatility. But that didn’t stop a sophisticated show like NBR
from blaming hedge funds for a non-existent volatility. 
Note to the media: Please do a better job of doing your homework!


 


Peter Navarro is a business professor at the
University of California-Irvine (www.peternavarro.com). 
Matt Davio is a managing partner at the hedge fund, Infinium Partners. For
investment management services, contact Matt at

infinium@peternavarro.com.   Contact Peter at

peter@peternavarro.com

 

 

 

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