Hedge Funds Are Scapegoats for Waning Volatility:
Mark Gilbert
Oct. 28 (Bloomberg) -- Hedge funds, already the usual suspects whenever financial markets go awry, stand accused of suffocating the very market anomalies they rely on to beat their less adventurous peers in the investment community.
The ``prosecution'' alleges that with $866 billion chasing identical strategies, any arbitrage opportunities in markets where hedge funds are active disappear too fast for anyone, including the hedge funds, to make a buck. It all smacks of sour grapes from those who either regret not jumping on the hedge-fund bandwagon, or are struggling to turn a profit this year.
Traders and investors feed on volatility. The bigger the price swings of a stock, bond, commodity or whatever, the greater the profit potential. When markets flatline, it's harder to make money or, to use the current odious idiom, to ``generate alpha.''
Volatility is waning in several markets. The most widely used measure is the Chicago Board Options Exchange's contract for the S&P 500 index, known as the VIX index. It lets traders and investors speculate on the rate of fluctuation for U.S. stocks.
So far this year, the average value of the contract has been about 16 points. That's down from 22 in 2003, 27 in 2002 and 26 in 2001, and from peaks of more than 40 in 2001 and 2002. To pull up the chart, click on {VIX <Index> GP W <GO>}.
The European version, Deutsche Boerse AG's contract on the German DAX index, shows a similar picture, with an average value this year of less than 20 compared with 32 last year and 35 in 2002. See {VDAX <Index> GP W <GO>}.
Tough Trading
Equity values, in summary, aren't moving around a whole lot. Given that the bulk of hedge fund managers rely on so-called long/short equity trading -- buying stocks they reckon are undervalued, and selling overvalued shares they don't own -- that makes for a tough trading environment.
In its study on ``Implications of the Growth of Hedge Funds,'' published in September 2003, the U.S. Securities and Exchange Commission says ``long/short equity is the most frequently used strategy among hedge funds,'' with 45 percent to 60 percent of hedge funds relying on that trading technique. Provided the difference in value between the undervalued and overvalued stocks narrows, the strategy delivers profit no matter which way the stock market moves.
Lackluster Returns
With stocks looking comatose, hedge funds are struggling to deliver the kinds of returns their investors have become accustomed to. According to an index of hedge-fund returns compiled by Credit Suisse Group and Tremont Capital Management Inc., they've made about 3.8 percent this year, down from 15 percent last year. While that's better than the 0.2 percent advance in the S&P 500 this year, it's not very thrilling.
Investment banks are also struggling to make money from trading. Third-quarter revenue at Citigroup Inc. declined 12 percent at its fixed-income unit and 14 percent in its equities business. At Merrill Lynch & Co., the drop was 11 percent in debt and 15 percent in equities, while JPMorgan Chase & Co.'s fixed- income revenue slid 23 percent, though equity-market revenue climbed 46 percent.
Bond market volatility is shrinking. The 10-week volatility for returns on U.S. Treasuries maturing in 10 years and more is down to a two-year low of 6.7 percent, after spending most of last year above 10 percent. Click on {USG5TR <Index> HVG W <GO>} for the chart. In Europe, returns on bonds repayable in 10 years and more have a 10-week volatility of 4.8 percent, down from more than 6 percent a year ago and more than 10 percent from June 20, 2003, to Aug. 15, 2003. See {EUG5TR <Index> HVG W <GO>}.
Less to Exploit
A research study by JPMorgan shows waning volatility elsewhere in bonds. There's typically been extra yield available for securities with maturities of about 13 months, deemed too long- dated for money-market investors and too short-dated for bond fund managers, the bank said in a research note.
In the U.S., U.K. and European markets, you could squeeze 33 to 50 basis points by exploiting that discrepancy from 1991 to 1997. Now you can get less than 13 basis points.
``It's impossible to prove this decline in term premia is due to hedge fund arbitrating of this initial mispricing,'' wrote Jan Loeys, JPMorgan's global markets strategist. ``But it is at least consistent with it, and with the types of trades hedge funds have been doing. As they grow larger, they will eventually erode the same market opportunities and mispricings they have relied on to create their superior returns.''
Whipping Boys
Not everyone agrees. ``Can you name one market movement these days where the hedge funds haven't been labeled as the cause?'' says Bob Sloan, managing partner at New York-based S3 Asset Management, which provides financial and trading services for hedge funds. Just as Arab investors were blamed for dislocations in the 1970s and program trading was the 1980s whipping boy, Sloan says blaming hedge funds is just an excuse ``for really not thinking through the mechanics of the market.''
The decline in volatility is certainly puzzling. The outlook for the global economy is about as unreadable as it gets. The U.S. presidential election looks set to prompt the mother of all legal battles at the first sniff of a hanging chad. And the longer the world goes without a major terrorist attack by al-Qaeda, the more deadly the next outrage seems likely to be.
One possibility is that as markets grow more sophisticated and information is disseminated more quickly, the ``rational markets'' hypothesis kicks in. Prices jump around less because they already reflect all the available pertinent facts, and adapt calmly to new data and events.
Stripping Out Volatility
In the same vein, the derivatives market makes it easier to strip out the component risks embedded in a given security, including volatility. The ability to trade volatility separately from other value determinants, such as creditworthiness or interest-rate moves, effectively increases the supply of volatility, and the laws of supply-and-demand do the rest.
Hedge funds aren't going away, even after the SEC's decision earlier this week to increase its oversight of the industry and make hedge-fund managers register with the agency. Nashville, Tennessee-based research group Van Hedge Fund Advisors International Inc. predicts the funds will oversee $1.7 trillion by 2008, about double their current assets.
Their size makes hedge funds a handy target. Oil at $55 a barrel? Hedge funds. Copper surging 60 percent in a year, then dropping 10 percent in a single session? Hedge funds. Baltic Dry Freight rates for shipping goods down 45 percent from January to June, then rebounding 80 percent in four months? Hedge funds.
When the search for a scapegoat begins, it's often a sign that a particular market move has run its course. Just as nature abhors a vacuum, markets detest inaction. The decline in volatility is unlikely to persist -- and when it rebounds, guess who'll get the blame? |
