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What Sparked the Selloff

Heavy forced selling by highly leveraged hedge funds is partly to blame for the recent market bloodbath.

By Steven Goldberg, Contributing Columnist, Kiplinger.com

November 13, 2008

A bunch of high-profile hedge-fund managers came to Capitol Hill on October 13 and testified that they and their funds were not to blame for the current financial mess. Maybe. But hedge funds are hardly innocent bystanders.

Whenever there's a bear market, the so-called experts usually blame individuals -- or "retail," as they call rank-and-file investors. Indeed, individual investors have beaten a hasty retreat from stock funds, selling an estimated $68 billion in October, or 1.4% of total stock-fund assets, according to TrimTabs Investment Research. That's a one-month record.

But the real blame for this bear market belongs with the professionals. First, of course, investment banks poured hundreds of billions of dollars into subprime-mortgage securities and other toxic paper. They magnified their bets as much as 30-fold by investing borrowed money. The industry essentially destroyed itself.

But investment bankers aren't the only culprits in the market tragedy. When the history of this era is written, hedge funds will merit a few chapters, too. Hedge funds are virtually unregulated investment pools intended only for wealthy and supposedly sophisticated investors. Like investment bankers, they love borrowed money, often leveraging their bets by 5-to-1 or 10-to-1.

Hedge funds were allowed under the laws enacted after the 1929 stock market crash. But they were restricted to individual investors with substantial assets -- at least $1 million -- and to institutional investors, such as pension funds. What's more, they were originally designed to "hedge" investors' exposure to stocks. That is, a classic hedge fund might have 50% of its assets in stocks and the other 50% in short sales -- bets that certain stocks would fall in price.

But all that changed. Near as I can tell, David Swensen, who has done a superb job managing Yale's endowment, played a big role in their transformation. So did the disastrous 2000-02 bear market, which prompted pension-fund managers to look elsewhere for healthy returns.

In his 2000 book, Pioneering Portfolio Management, Swensen said his success involved surrendering the ability to sell securities easily (liquidity) and, instead, investing in such assets as commodities, real estate, private equity (as opposed to stocks traded on exchanges) and hedge funds.

Like lemmings, pension funds and other institutional investors followed his lead, hoping to garner the stellar returns he achieved. But while Swensen is a gifted investor and a clear writer, his methods were not easily learned. Any pension-fund manager can invest in private equity and hedge funds, but few can do it with the success Swensen achieved. Most lost their shirts.

Like a cancer, hedge funds spread to other investors. "Funds of hedge funds" enabled almost anyone, regardless of net worth, to gain exposure to hedge funds.

What were they buying? Few hedge-fund investors knew. Several factors distinguish hedge funds from ordinary mutual funds. First, they're almost completely unregulated. Disclosure is sketchy, at best. Second, they often employ exotic and high-risk strategies. They may, for instance, speculate in currencies or commodities, or execute complex options strategies. Third, they often employ leverage.

And then there are fees. Hedge-fund managers are paid unconscionable sums of money. While the typical mutual fund may charge annual expenses of 1% -- which generates a fortune for a fund of any size -- hedge funds cost much more. They typically charge "two and twenty"--that is, 2% annually of the assets under management, plus 20% of any profits. (Of course, they don't share in a hedge fund's losses.)

I talk to mutual fund managers all the time. Three good years' worth of returns running a hedge fund, many say, and you'd have enough money to buy anything you wanted for the rest of your life. You'd have tens of millions of dollars -- at least.

No wonder managers with good records flocked to hedge funds -- and investment bankers, brokerages and others devoted major efforts to marketing them. The few truly talented hedge-fund managers were vastly outnumbered by the marginally qualified and the incompetent. By last summer, some $2.8 trillion was invested in hedge funds, according to the best estimates. Because they are so lightly regulated, no one really knows how much is invested in them.

Nor does anyone truly know how hedge funds are investing or what their returns have been. There's no question, however, that performance has been dismal. A Morningstar hedge-fund index reports average returns of -13% for the year through September 30 -- before the stock market really collapsed.

As their own businesses fell apart, investment bankers and brokerages called in loans to many hedge funds. When stocks plunged, hedge funds got more and more margin calls, forcing them to sell more and more stocks -- setting off a vicious cycle.

How much of October and early November's market breakdown had to do with forced selling by hedge funds? We'll never know precisely, but my guess is that it was a major contributor. As the market decline became more intense, correlations between different kinds of investments increased markedly. Thus, hedge funds that invest in commodities or real estate suffered as badly as did hedge funds that invest in stocks. Everything went down -- and forced selling by hedge funds fueled the conflagration.

What of the future? Many hedge funds have already folded, and more will follow. I, personally, see no reason for the industry to continue to exist. Alan Greenspan argued years ago that hedge funds would bring more liquidity to the markets -- that is, make it easier to buy and sell securities without disturbing their prices. In fact, they did exactly the opposite. They brought record volatility and helped spark a market implosion that imperils our financial system and our economy.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.

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