Clipped Hedges
By James Grant
Forbes Magazine
Thursday May 23, 6:39 pm Eastern Time
When things like hedge funds actually acquire a mass market following, some kind of disaster is just around the corner.
Carrefour last month disclosed plans to sell hedge funds in French supermarkets. "We want to democratize the hedge fund business," Thierry Gosset, administrative director for financial services of the world's second-largest retailer, told Bloomberg News. "We aim to achieve the necessary critical mass by attracting many small investors." Minimum investment: the equivalent of $900.
There is only one place in which a conscientious grocer would display an assortment of hedged investment products: He would set them out in the perishables case. Like a head of lettuce, a leveraged investment partnership easily wilts.
In all times and all markets, excess is a leading indicator of peril. In the breakneck proliferation of hedge funds, excess is turning into absurdity. According to the New York Times, the worldwide population of hedge funds is approaching 6,000. With the help of $144 billion in new money, assets climbed 38% last year to $563 billion.
The exact nature of the risk posed by the rapid placement of these hundreds of billions of supposedly sophisticated dollars will be revealed, as usual, too late (see Forbes, Aug. 6, 2001). However, even before the inevitable pileup, we can perceive the outlines of trouble. Ostensibly, hedge funds are hedged. Most certainly, they are leveraged. The risk lies in the debt-and the collective inexperience of the managers and investors.
A half-century ago Alfred Winslow Jones, an ambitious ex-financial writer, had an idea. He would invest $100 in the stock market. He would borrow $30 and invest that, too. To mitigate the risk of the extra $30 of long exposure, he would sell short $30 of stock (i.e., sell borrowed shares with the expectation of buying them later, possibly at a lower price). He would, as the phrase went, be "short against the increment."
If his stock selection was good, Jones reasoned, he would be more than fully invested. But, to be on the safe side, he would hedge. He called his fund a "hedged" fund. It is telling that, down through the years, the final consonant has gone missing.
Which brings us to Jones' progeny. No doubt hundreds, even thousands, of these offspring are faithful to the founder's vision. With complete certainty, we know that hundreds, even thousands, are not. We know something else. Not even the progenitor flawlessly implemented the A.W. Jones & Co. investment model. So bruising was the 1969-70 stock market downturn that Jones himself considered calling it quits.
Jones' preceding success did not go unnoticed. Many tried to emulate him, not forgetting the part about taking on some margin debt. By 1977 Institutional Investor asked where all the funds had gone. "Quite simply," the magazine answered, "what was larger than life on the upside was magnified on the downside, too--despite the apparent 'hedge' concept that was supposed to enable them to profit on their short positions. Performance fees, in an era of nonperformance, dried up."
Nonperformance today is almost preordained. Hedge fund promoters promise to be leveraged, to be hedged, to be "market neutral," to be short, to be long. The trouble is that there isn't enough ice water to fill the veins of all the fresh, young hedgies.
"He was all nerve and no nerves," it was said of a certain speculator a century ago. But for those with conventional nervous system wiring, nothing is quite like short-selling. Have you ever tried selling short, and then tried to get some sleep? For most people, the two activities are incompatible. Of course, the potential loss on a short sale is unlimited.
Rallies in bear markets are notoriously violent, and the mushroom growth of leveraged investment partnerships can make them even more explosive. On days like May 8, when the Nasdaq composite rose 7.8%, you could almost feel the sweat beading up on the brows of thousands of novice fund managers.
In April New York Stock Exchange short interest reached a record high 6.8 billion shares, up 3% from March. The rise was reportedly driven by hedge funds. Although the absolute volume of short sales is touching a record high, the confidence level of the short-sellers must be near a record low. It is an open secret among seasoned bears that only a small fraction of short sales these days are the result of rigorous and original securities analysis. Nowadays more and more shares are sold for no better reason than that "the market is going down."
Democratize the hedge fund business? Sure, and as long as we're at it, let's democratize the New York Philharmonic. We'll all play first horn.
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James Grant is the editor of Grant's Interest Rate Observer. Visit his home page at www.forbes.com/grant. |
