HEDGE FUNDS AND YOU: YES, THERE'S A CONNECTION
At first blush, it may seem as though the high-tech world of hedge funds is far removed from your nest egg of mutual funds or blue-chip stocks. Hedge funds are private investment pools that are restricted to a small number of wealthy investors and thus slip under the radar of most securities regulations. That allows them to use an array of complex, often risky strategies, involving derivatives, shorting, and buying on margin, in hopes of increasing returns and minimizing risks. They have grown increasingly popular with individuals as the long bull market created more millionaires who could meet their stiff minimum investment requirements, often of $500,000 or more, yet they remain vehicles solely for the investing elite.
Indeed, while Wall Street has been enamored of quantitative strategies - the arcane mathematic models that form the underpinnings of many hedge funds -- mutual funds built on "rocket science" haven't caught on with the investing public. "It's very hard to warm up to a quant fund," says Russ Kinnel, a fund analyst at Morningstar Inc. Most investors prefer to see a flesh-and-blood portfolio manager calling the shots, rather than a computer, although, Kinnel adds, many funds probably use quantitative strategies without advertising the fact.
A few mutual funds that use quantitative strategies have suffered steep declines this year. But Kinnel says the percentage of quant funds that have suffered this fate is no greater than the percentage of all mutual funds that have fallen significantly. That may be thanks to securities laws that restrict mutual funds from making some of the same gambles that hedge funds are free to, such as buying stocks on margin or selling them short.
CLOSE SCRUTINY. While rocket science gone awry hasn't had a direct impact on most people's portfolios, the strategies of the hedge-fund heavy hitters bear watching. All investors have felt ripple effects created in part by some of the imploding hedge funds. In fact, it's becoming clear that some highly leveraged funds that engage in currency trading or invest in emerging-market stocks and bonds are magnifying the volatility in all markets. For instance, many analysts believe that hedge-fund managers facing margin calls in Russia brought about the recent steep declines in Latin American markets when they sold holdings there to come up with the cash. That domino effect has compounded fears of a global economic crisis that have caused U.S. markets to plummet.
"In every sharp stock market decline there has been some mechanism which turns small declines into big declines," says Hugh Johnson, chief investment strategist at First Albany. "In 1929, it was margin debt. In 1987, it was 'portfolio insurance.' In 1998, it is margin debt again. But this time it is not individuals, it is hedge funds that have borrowed money to make substantial bets."
Of course, hedge fund losses alone did not create the market's current problems. But they almost certainly have added to the "disorderly and irrational" quality of the sell-off, says Johnson. That ultimately is why investors should at least pay attention to the activities of hedge funds. "It helps you put the decline in its proper historical context and, from that point of view, it is encouraging, because you know that what is currently happening is very normal," Johnson adds. If investors understand why declines are so sharp and steep, they will feel more comfortable riding out the storms, he hopes.
In fact, even though hedge-fund losses may increase short-term volatility and compound investor anxiety, fundamentals will win out in the end, argues Rosellen Papp, co-manager of the Papp America-Abroad Fund. She thinks the market is declining mainly for emotional reasons and that true bear markets occur in the presence of high interest rates, inflation, or both. Right now, "you have none" of those, she says. Some members of the financial community "are confusing the woes of the hedge funds with the basic economics of what is going on," contends Papp, who thinks the U.S. is far from entering a recession. "I really don't care if we lose one or two hedge funds," she says.
FUN TO FOLLOW. Clearly, hedge funds are just one small contributor to the market's volatility. "I believe the finger is pointed too easily and somewhat unfairly at hedge funds," says George Van, of Van Hedge Fund Advisors International, a Nashville firm that advises investors on hedge-fund selection. Trading volume at large international banks has a much larger effect on currencies and markets, he says. But hedge funds attract more public scrutiny because they are easier to track as well as more fun to follow. "They are sort of a mirror of what's going on in some of the investment banks," Van says.
Hedge-fund proponents are quick to point out that a minority of funds, principally those using bond-related strategies, suffered dramatic losses in the August rout. Of the 14 categories of hedge funds Van tracks, only the funds that engage in currency trading, emerging-markets, or making macroeconomic calls -- the latter include funds run by George Soros -- have gotten into hot water. Hennessee Group, a New York firm that advises investors on hedge funds, reports that its index of hedge funds returned 8.56% in August, vs. a decline of 14.4% for the S&P 500 and 19.4% for the Russell 2000 small stock index. "Hedge funds clearly have performed better in aggregate," says E. Lee Hennessee, of Hennessee Group, adding that 51% of all hedge-fund managers are beating the S&P.
That may be so. But August has proven that the strategies of rocket scientists need only misfire at a few highly leveraged hedge funds and a handful of trading desks to rock global markets. That observation may not help ordinary folks avoid the mayhem. But it may keep them from panicking in the wake of all that volatility.
By Amey Stone, associate editor, Business Week Online
Updated Sept. 10, 1998 by bwwebmaster
Copyright 1998, by The McGraw-Hill Companies Inc. All rights reserved. |
