Exposing the Hedge Fund Industry's Soft White Underbelly

I have thought for a while that the hedge fund business model was breaking down. In fact, I turned down an offer to raise capital in a hedge fund format a few weeks ago. This summer it appears that the soft white underbelly of hedge funds is being exposed as the four legs of hedge funds are being kicked out right from under the industry:

• Leverage – Hedge funds need leverage to generate excess alpha and non-correlated returns. Leverage is being removed from the system like never before for hedge funds.
• Manipulative Short Selling – Short selling is a good thing. Manipulative short selling is illegal and against the interest of shareholders. That is now going to be enforced and put to an end. Next we will have the reinstatement of the up-tick rule. It worked for 70 years but failed us in the last year.
• Performance Fees – Many funds are closing up because the managers won’t earn performance fees. This resulted in massive liquidations which are still continuing.
• Lack of Transparency – The SEC took the first step in requiring hedge funds to report short positions over certain limits. Mutual Funds have to file reports with the SEC and provide shareholders with a quarterly report which is part of the SEC filing. The wall of transparency will be brought down.

So what will happen? Eventually we will see assets flow back to more traditional forms of investment – managed accounts, mutual funds and self directed investments.

Disclosure: None

Comments

[mdmrjsds:]

I can't agree that shorting is a good thing. It is price manipulation, and so can be abused. I don't think it is necessary to the proper function of stock markets. Prices will still fall, they just won't fall so precipitously. The stability is worth any loss in efficiency, and I think it will allow risk to be priced in more correctly (obviously risk hasn't been priced correctly up to now given the meltdown).

And I've read an article here on SA that suggested that the uptick rule is irrelevant in the era of computer trading because computers can be programmed to do a buy trade and then a large sell trade almost instantaneously.

So perhaps it would be more appropriate for the rule to be that you can't short unless the stock price has just risen some fraction of a percent, say 1/10%, or a fixed amount, say ten cents. The advantage of a fixed amount is that it gets harder to short a stock as it falls. That would make it much harder to game the rule, and also to kill a company. And it allows tuning. So if it isn't effective at ten cents, you can try 20 cents.

2008 Sep 22 06:02 PM

[helplessobs...:]

There is nothing wrong with short selling by the rules. It protects your portfolio in down markets and the shorts are aggressive buyers in down markets where there are mostly sellers. With short selling prohibited on many stocks these stocks will be decimated by panic owners whose's only recourse is to sell out and not neutralize or hedge their position by a short sale.

2008 Sep 22 09:15 PM

[rogerk2:]

I'd guess 90% of retail investors haven't a clue how to hedge their portfolios with shorts, puts, hedge clippers, or anything else. They call the broker, who tells them what to buy. Unless they're worth millions, the broker never calls to tell Grandma and Grandpa it's time to put on an options collar or pair trade.

Grandma and Grandpa saved all their lives and now live on the income from their long term investments. All of a sudden (to them), their stocks are worth crap because a bunch of shysters have shorted them into oblivion. All they can do is sell, and get peanuts. That's all they know how to do.

While all you sophisticated traders are crying the blues about the death of your golden calf, how about considering that you have ruined a whole lots of people's lives. People who believed in prudence, frugality, and the fairness of the American free market system.

2008 Sep 23 01:23 AM