Credit Turbulence Puts Hedge Funds on the Spot

Date: Saturday, March 17, 2007
Author: Chet Currier, Bloomberg

March 16 (Bloomberg) -- Are hedge funds really the disruptive, destabilizing force their critics make them out to be?

Or do these free-wheeling partnerships of wealthy and institutional investors actually reduce volatility and help make the financial markets run smoother?

Those long-debated questions may soon be put to a telling real-life test. If credit turmoil spreads from the carnage in the subprime mortgage business, hedge funds stand to become the featured players in a heroes-or-villains drama.

It all depends on how events play out in the stock, bond, currency and commodity markets. Should the shakeup that began in late February turn into a messy, drawn-out affair, hedge funds are handy candidates for blame.

They are understood to be prime practitioners of the so- called carry trade, which uses money borrowed from a cheap source such as the Japanese money market to invest for a presumed higher return somewhere else. Protracted shakeouts in higher-risk investments, such as emerging-markets stocks and the more exotic corners of the bond market, are bound to be accompanied by howls about the unwinding of the carry trade.

On the other hand, should market tumult last only a short while, hedge funds will be well placed to claim a big share of the credit. They enjoy the ability to play a market from any side --and are accustomed to acting fast as they compete fiercely among themselves to profit on every pricing anomaly, however fleeting, that may arise.

Lingering Effects

In days of yore, sudden declines in security prices could cast emotional shadows over the markets for months afterward. Once burned, investors were twice shy about venturing into the fray again.

The prototypical hedge-fund manager doesn't think that way at all. Rising market, falling market, it's all the same to him as long as there are some decent-sized fluctuations to work with.

With an estimated $1.4 trillion in assets, hedge funds amount to only a small fraction of the size of mutual funds, which hold more than $10.5 trillion in the U.S. and $20 trillion worldwide. But very little of mutual funds' immense firepower is held in reserve and available to be used at any given time.

Most mutual funds follow a fully invested, long-only strategy. At last report by the Investment Company Institute, U.S. stock funds had cash reserves totaling just 4 percent of their assets. They can't very well step forward to support the markets when practically all of their money is already committed there.

Private Equity

What about private-equity funds, a highly visible source of demand for stocks in recent times? Much of their activity is financed with borrowed money, which could dry up in a flash during any kind of a credit crisis.

Market cycles tend to be magnified, not mitigated, in private equity -- lots of enthusiasm in boom times, lots of wariness when risk is in the air.

The beauty of hedge funds is their ability, at least in theory, to operate free from the shackles of the usual emotions and psychology of the marketplace. Yes, hedge-fund managers and their clients live in a climate of greed and fear, just like every other investor -- maybe more so, given the degree of risk hedge funds are prone to take.

Nevertheless, in hedge-fund investing there's precious little room for the behavioral-finance failings that so often befall more conventional investors.

Staying Cool

It's easy to form a sentimental attachment to a stock or mutual fund that has been in the family for 20 years. That's not likely to be a problem when you are dealing in commodity-futures straddles or credit-default swaps.

Hedge-fund managers have often been portrayed not merely as dispassionate, but as pitiless self-seekers wielding frightening amounts of power. Recall how hedge-fund superstar George Soros was dubbed ``the man who broke the Bank of England'' after he and other speculators drove the British pound out of Europe's system of linked exchange rates in 1992.

Well, a measure of cold calculation may be just what is wanted when most investors get caught up in the emotions of a turbulent market. While the herd is stampeding in one direction, nobody is better equipped than hedge funds to get a little movement going the other way.

(Chet Currier is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Chet Currier in Los Angeles at ccurrier@bloomberg.net