The Evolution of the Hedge Fund Industry

The evolution of the hedge fund industry into a few unimaginable behemoths is reducing financial markets to mere battle grounds, ever-more detached from economic reality. In 1999, in the aftermath of the LTC debacle, the Federal Reserve, Treasury, SEC and CFTC published Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management in an attempt to preempt future occurrences. At the time they reported:

With $200 - $300 billion spread among approximately 3,000 hedge funds, most hedge funds are relatively small, with the vast majority controlling less than $100 million in invested capital. In fact, according to commodity pool operator (“CPO”) filings with the CFTC, there are perhaps only a few dozen hedge funds today that have a capital base larger than $1 billion, and only a small handful that exceed $5 billion.4 The very largest hedge funds have less than $12billion in investor capital, although some “families” of funds have greater stakes. Although individually and as an industry, hedge funds represent a relatively small segment of the market, their impact is greatly magnified by their highly active trading strategies and by the leverage obtained through their use of repurchase agreements and derivative contracts.

Eight years later . . . the top 10 hedge funds - - count them on two hands – now control about 270 billion, 1/10th industry's aggregated assets of 2.5 trillion. After LTC and the most recent headline flameouts, does anyone consider the individual, potential power of their leveraged trading impact, let alone two or more of them have the same idea? Together, and with only LTC-style-leverage, that could translate into roughly 1/7th of average trading volume on the NYSE!

Equities markets have been democratizing and now enjoy about 60% participation across our fruited plain. Participation has grown in part because financial oversight agencies have enacted layers upon layers of regulations. Yet even after a near collapse of the system in 1998, hedge funds remain virtually out of the regulatory loop. By catering only to the affluent (and all too many politicians), they are effectively sidestepping decades of regulations designed primarily to protect John Q. Public. Was it Jack Sparrow or Jesse Livermore who said “the only rules are what a man can do and what a man can’t do.” Concentrated leverage can support its own reality and become a brilliant algorithm. There is only so much profit in a zero-sum world, as evidenced by the quickly shrinking population of hedge funds. Is it a brilliant algorithm or simply thinning the field? After all, how can you make a quick buck without the help of the public? It is a war of attrition and our markets are the battlefield.

Even a market made illogical by design must eventually revert to economic reality, if only for an instant. Although there is enough collective insanity to explain the recent volatility, I would certainly like to see mathematical proof that some brilliant algorithm is decoding and not manufacturing it. Absent effective regulation to reinsure a democratic marketplace, we had better get used to a daily diet of dire straits.

Comments

[Dawson Lodge:]

Excellent article. I enjoy the heads-up approach to this casino we call a market. "decades of regulations designed primarily to protect", Regulation is a joke, CFTC does pretty well, but SEC is corrupt, useless, and doesn't protect anybody. Did they help with Enron? How about the $6 trillion lost in the 2000-2003 crash? How about allowing these funds to operate on ridiculous amounts of leverage, drastically increasing their influence on the markets way beyond any realistic economic measure. Off-exchange derivatives -swaps, on options, on futures etc is so far from real markets as to be laughable. The idea of public disclosure to assist price discovery in a free market is out the window. The "surprise-theory of economics" has supplanted even the discredited Keynesian school. The mortgage securities meltdown is just the first sign of this "pie-in-the sky" financial market. Every 5 bucks taken out of the banks deflates their balance sheets by $100.
The air is leaking from the baloon.Market transparency is possible in real time via the internet. Regulation is a fraud for the purpose of making sheep think everything is OK. Nothing could be further from the truth........

2008 Jan 05 03:25 PM