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Hedge Funds: The New Dumb Money

)Much of the fury in yesterday’s nearly 500 point “melt up” in the Dow was generated by hedge funds panicking to cover shorts. Convinced of the imminent collapse of Europe, the impotence of governments, and the death spiral in sovereign bonds, many managers were running a maximum short position at the Monday opening, and for the umpteenth time, were forced to cover at a loss. Meet the new dumb money: hedge funds.

When I first started on Wall Street in the seventies, you heard a lot about the “dumb money.” This was a referral to the low end retail investors who bought the research, hook-line-and-sinker, loyally subscribed to every IPO, religiously bought every top, and sold every bottom.

Needless to say, such clients didn’t survive very long, and retail stock brokerage evolved into a volume business, endlessly seeking to replace outgoing suckers with new ones. When one asked “Where are the customers’ yachts”, everyone in the industry new the grim answer.

Since the popping of the dot-com boom in 2000, the individual investor has finally started to smarten up. They bailed en masse from equities, seeking to plow their fortunes into real estate, which everyone knew never went down. Since 2008, the exit from equities has accelerated. There have been over $400 billion in redemptions of equity mutual funds, compared to $800 billion in purchases of bond funds.

Although I don’t have the hard data to back it, I bet the average individual investor is outperforming the average hedge fund in 2011. With such heavy weightings of bonds and cash, how could it be otherwise. While the current yields are miniscule, the capital gains have to be humongous this year, with yields plunging from 4% to 2%.

This takes me back to the Golden Age of hedge funds during the 1980’s. For a start, you could count the number of active funds on your fingers and toes, and we all knew each other. The usual suspects included the owl like Soros, the bombastic Robertson, steely cool Tudor-Jones, the nefarious Bacon, the complicated Steinhart, of course, myself, and a handful of others.

The traditional Wall Street establishment viewed us as outlaws, and believed that if the trades we were doing weren’t illegal, they should be, like short selling. Investigations and audits were a daily fact of life. It wasn’t easy being green.

It was worth it, because in those days, if you did copious research and engaged in enough out of the box thinking, you could bring in enormous profits with almost no risk. I used to call these “free money” trades. To be taken seriously as a manager by the small community of hedge fund investors you had to earn 40% a year, or you weren’t worth the perceived risk. Annual gains of 100% were not unheard of.

Let me give you an example. In 1989, you could buy a warrant on a Japanese stock near parity, for $100 that gave you the right to own $500 worth of stock. You bought the warrant and sold short the underlying stock. Overnight yen yields then were at 6%, so 500% X 6% = 30% a year, your risk free return. If the stock then fell, you also made money on your short stock position. This was not a bad portfolio to have in 1990, when the Nikkei stock index plunged from ¥39,000 to ¥20,000 in three months, and some individual shares dropped by 80%.

Trades like this were possible because only a smaller number of mathematicians and computer geeks, like me, were on the hunt, and collectively, we amounted to no more than a flea on an elephant’s back. Today, there are over 10,000 hedge funds managing $2.2 trillion, accounting for anywhere from 50% to 70% of the daily volume.

Many of the strategies now can only be executed by multimillion dollar mainframe computers collocated next to the stock exchange floor. Winning or losing trades are often determined by the speed of light. And as the numbers have expanded exponentially from dozens to hundreds of thousands, the quality of the players has gone down dramatically, with copycats and “wanabees” crowding the field.

The problem is that hedge funds are no longer peripheral to the market. They are the market, and therein lies the headache. How are you supposed to outperform the market when it means beating yourself? As a result, hedge fund managers have replaced the individual as the new “dumb money, buying tops and selling bottoms, only to cover at a loss, as we witnessed on Monday.

The big, momentum breakout never happens anymore. This is seen in hedge fund returns that have been declining for a decade. The average hedge fund return this year is a scant 1%. Make 10% now and you are a hero, especially if you are a big fund. That hardly justifies the 2%/20% fee structure that is still common in the industry.

When markets disintegrate into a few big hedge funds slugging it out against each other, no one makes any money. I saw this happen in Tokyo in the 1990’s, when hedge funds took over the bulk of trading. Volumes shrank to a shadow of their former selves, and today, Japan has fallen so far off the radar that no one cares what goes on there. Japanese equity warrants ceased trading by 1995.

How does this end? We have already seen the outcome; that investors flee markets run by hedge funds and migrate to those where they have less of an impact. That explains the meteoric rise of trading volumes of other assets classes, like bonds, foreign exchange, gold, silver, and other hard assets.

Hedge funds are left on their own to play in the mud of the equity markets as they may. This will continue until hedge fund investors start departing in large numbers and taking their capital with them. The December redemption notices show this is already underway. Just ask John Paulson.