its just a matter of time; an article for the thread; there is a lesson in this piece about Contrivance, within that lesson you should learn that derivative constructs, are originating from a category of actors who have shown little or no understanding of the free markets they are attempting to influence. So it is no wonder that eventually thier lack of base understanding, will interrupt thier correlations mid stream. enjoy the article.
Hedge funds poised for harsh phase of evolution
By John Authers
Published: October 18 2008 03:00 | Last updated: October 18 2008 03:00
Hedge funds are the Galapagos islands of the financial services industry. So at least says Andrew Lo, the Massachusetts Institute of Technology economist who has pioneered the application of evolutionary biology to markets.
According to Mr Lo and many of his acolytes, markets are not efficient, as had been assumed by academics for the past generation, but rather they are adaptive, with participants following Darwinian rules. After periods of relative stability they will undergo periods of intense change as participants evolve to take account of new realities.
Hence hedge funds are markets' Galapagos, the islands whose unique eco-system allowed Darwin to work out his theory of evolution, because evolution there happens so fast. Lightly regulated, hedge funds offer the closest we have an experimental laboratory for testing which ideas for making money will prove to be the fittest.
For much of this decade, hedge funds had appeared to evolve far more nimbly than their lumbering cousins in the regulated financial industry. At the beginning of this decade, as the conventional "long-only" equity funds that dominate the retirement saving industry were suffering severe losses in the wake of the bursting of the internet bubble, hedge funds avoided losses.
That spurred huge new investments by wealthy individuals. If, during the 1990s, the "marginal investor" in equities was a mutual fund manager, in this decade that title moved to hedge fund managers. They dominate trading volumes and, in the short term, move markets.
What let them survive and flourish? Apart from being small, nimble and, in some cases, smart, they had three key advantages.
Unlike most conventional funds, they can sell stocks or commodities short, to profit from declines in price. They can borrow; a trade that makes not even 1 per cent is worth doing if you borrow enough money to make the same trade 10 times. And they can limit withdrawals by investors, allowing them more flexibility than funds that must be prepared for redemptions every day.
For the first year of the credit crisis that began last July, they remained at least one evolutionary step ahead of the herd. Judged as a sector (which covers a multitude of species), they continued to make money as equity funds lost badly.
Meanwhile, equity returns were themselves baffling. In early September, a day after the giant US mortgage agencies, Fannie Mae and Freddie Mac, had been nationalised, the credit crisis was more than a year old and the MSCI World equity index was down only about 22.9 per cent from its peak - far less damaged than the credit markets.
But something happened to disrupt the delicate ecology of the Galapagos. Hedge fund indices differ widely but they agree that hedge funds started to lose money in July - and lost it in a big way last month.
Why? This must be guesswork, but a popular hedge fund strategy involved selling short the stocks of banks while betting on energy prices to increase. The argument was that lower rates to combat the credit crisis would feed through into inflation and cause funds to flow into oil.
In the year to mid-July, this trade netted 345 per cent. But then the oil bubble burst. Since then, the "long oil short banks" trade has lost 57 per cent.
The end of September gave hedge fund investors one of their periodic opportunities to remove money. It appears many took it. According to Hedge Fund Research, $31bn was yanked from the sector in the third quarter, while investment losses reduced their assets by $210bn. TrimTabs estimates that withdrawals were even higher, at $43bn in September alone. Meanwhile, the Lehman Brothers bankruptcy in mid-September prompted a sudden increase in the price of leverage as investment banks on whom hedge funds rely for their short-term funding applied much tighter restrictions.
Then came the ban on shorting financial stocks. All hedge funds' critical evolutionary advantages had been removed. Once hedge funds cracked, equity markets also cracked, with the MSCI World index falling more than 30 per cent since early September. The "crash" of last week was followed by the most volatile week in history, with huge and utterly illogical swings as funds struggled to reconcile their positions, particularly in the energy sector. On Thursday afternoon alone, while oil prices fell, the S&P energy index rose 14 per cent, raising its market value by about $140bn. Hedge funds were the marginal investor.
Leverage, it appears, was vital to the eco-system of the Galapagos. As the chart shows, hedge funds' great outperformance dates from a period when leverage (proxied by the three-month Libor interbank lending rate) was historically cheap. While markets stayed stable, that leverage made hedge funds look much nimbler than the rest.
The removal of leverage may not administer the same shock to hedge funds as the asteroid that eliminated the dinosaurs but they now face a new phase of evolution - in a far more hostile environment.
john.authers@ft.com
Copyright The Financial Times Limited 2008
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