Sent: 22-04-2008 11:54:01
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Pariahs - Part 2
Last time I outlined the accusation that the current turmoil in the markets was caused by market manipulation undertaken by hedge funds, who then went on to profit from that manipulation. This time I shall concentrate on the reasoning behind that accusation.
As the celebrated commentator writing in the New York Times argued, many recent events in the global markets simply cannot be explained by fundamentals. He suggests that the havoc in the markets for securities based on sub-prime mortgages far exceeds the actual losses on those loans. He cites by way of example the fact that municipal bond market and markets for short-term municipal and corporate "auction" securities are also in havoc, even though there have been no notable defaults in these areas.
I am glad to say that he does concede that losses in various types of securities are nothing new but goes on to add that what is new are hedge funds and the "changing of Wall Street from a financing entity to a market manipulation entity". Strong words indeed. Further, he goes on to argue that because hedge funds have so much money and so much selling power, they can make money not by betting on the markets, but by controlling the markets. This is done by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets.
As a result, hedge funds clean up by betting on falling prices.
He even explains it for his readers by illustrating that in such circumstances the hedge funds can, for example, borrow vast amounts of stock and sell them at current prices, causing an excess supply that drives prices down. They subsequently buy the shares back at the lower price to repay their lenders, profiting on the difference between the sales and purchase prices.
As the experts at Wharton point out, similar strategies use stock options and other stock and fixed-income derivatives. However, while short sales are a legal and common way to bet on the prospects of falling prices, it is illegal to conduct a "bear raid," where the stock-price manipulation is intentional and often accompanied by the
spreading of false rumors.
Now comes the classic conspiracy theory bit. Because hedge funds are secretive and report results only voluntarily, it is hard to know just what all of them are doing. He then supports his argument by the selective use of statistics. He cites surveys conducted by Chicago-based Hedge Fund Research that show the average hedge
fund returned nearly 10% in 2007, compared to 5.5% for the Standard & Poor's 500 index.
He goes on to demonstrate that in 2008, hedge funds lost about 0.5% to the end of February, while stocks were down just over 9%. Further, he illustrates that HFR's Short Bias Index, that tracks hedge funds using strategies that profit when prices fall, was up more than 6% this year to the end of February, beating the stock index by 15 percentage points.
All this sounds impressive until you actually use some more statistics.
Hedge funds that specialize in short sales make up a relatively small proportion of the hedge fund market, holding less than US 5 billion in assets at the end of 2007. This is compared to a total hedge fund market of around US US2 trillion in assets at that time.
Then there are the mutual funds, which (in the US at least) are not allowed to engage in short sales. They represent almost US12 trillion in assets.
As one of the Wharton experts points out, whilst it is possible for hedge funds to temporarily disrupt the market, causing major disruptions is altogether another thing, especially in the area that lies at the root of the problem.
More next time.
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