Hedges Are About to Roll

Hedge funds are the new “dumb money.” At least that’s what so many of my institutional clients are telling me. And they should know, considering they’re hedge funds themselves.

Don’t get me wrong. My clients are the larger hedge funds that have been around for years, battle-tested in bull markets and bear markets. The ones they’re referring to are the literally thousands of brand new hedge funds that have opened their doors in the past three years. According to my clients, the way to make money is to figure out what the new kids on the block are doing, and then do the opposite.

There’s no one investment strategy that all hedge funds follow. For many — most, perhaps — it’s hard to argue that they even hedge. What they all have in common is that they are regulated more loosely than mutual funds, because their money comes exclusively from high net worth individuals and institutions. And most of them use leverage. That is, they borrow money to take positions larger than their actual capital base, which can amplify returns both in good times and in bad.

Another thing they almost all have in common is high fees. A typical hedge fund charges a basic annual fee of 2% of assets under management (higher than the typical mutual fund). And then on top of that, the typical hedge fund takes 20% of any profits (mutual funds almost never share in profits).

The thousands of new hedge funds — as a subset of all hedge funds — tend to have some things in common among themselves, too. Because they have all gotten started in the past couple of years, you can be sure they raised their initial funding by showing good recent track records. By definition, at this moment in history, that means all these guys are investors who were short stocks and long bonds at the top of the “bubble market” in 1999 and 2000.

Was it luck, or was it skill? Who knows. But it’s safe to assume that they’ve all told their investors it was skill. And I’ve been around this game long enough to know that even though that’s probably a lie, they actually believe it when they say it. Success goes to one’s head in this business.

That’s precisely the problem. These thousands of new self-proclaimed geniuses — now managing God knows how many hundreds of billions of dollars of other people’s money — think they’ve figured out the one true way to beat the market everywhere and always. But the market is a tougher game than that. Just when every new generation of geniuses has it all figured out, the game changes. What worked in the last cycle never works in the next cycle.

Remember, in 1999 and 2000 there was a wave of new hedge-fund managers, too. And who were they? Of course, they were the people who got into technology stocks and Internet stocks in the mid and late 1990s. They, too, were geniuses. They, too, had figured out how to beat the market everywhere and always. They were proven wrong. And so will be today’s hedge-fund geniuses.

The stock-market crash that began in 2000 trained today’s new hedge-fund managers to hate stocks. Alan Greenspan’s monetary deflation and the era of ultra-low interest rates trained them to love bonds. But, hey, it doesn’t take a genius to get trained like that. Pavlov did it with dogs just by ringing a bell before feeding them.

But just as Pavlov’s dogs learned to salivate whether or not there’s really any food in front of them, today’s new hedge-fund managers hate stocks and love bonds whether or not stocks are a bad investment and bonds are a good investment. At this point it’s just conditioned reflex.

So this week we’ve seen the 10-year Treasury bond rally back to a yield of as low as 4%. Yet at the same time, no less than three Federal Reserve officials — FOMC members Donald Kohn and Michael Moskow, and Atlanta Fed chief Jack Guynn — all said that inflation remained a threat unless interest rates continued to move higher. If the Fed continues to hike interest rates at every FOMC meeting this year, the fed-funds rate will stand at 4.25% by year’s end. It’s technically possible for the 10-year Treasury yield to be lower than that, at 4%, but such an inverted yield curve is a rare thing and generally indicates a severe recession just around the corner.

Such a forecast hardly seems the most likely explanation for where the 10-year is trading. More likely is that it’s simply in a bubble, pumped up by the new generation of hedge-fund geniuses.

In this, they are behaving just like the generation before them who pumped up the tech-stock bubble five years ago. Remember what they used to say then? Then, too, it didn’t matter how much the Fed was vowing to raise interest rates. Back then, interest rates didn’t matter to “New Economy” companies. Well, it turned out that they mattered a lot. Greenspan’s relentless campaign to stamp out “irrational exuberance” with high interest rates eventually worked all too well.

We’re in the last moments of the bond bubble. The new crop of hedge-fund geniuses are about to learn their lesson. You can see the signs already.

A couple of weeks ago hedge funds got clobbered in General Motors, when Kirk Kerkorian announced a tender offer to buy the company’s stock and then, a couple of days later, Standard and Poor’s downgraded GM debt to junk status. Of course the new hedge fund geniuses had it wrong both ways. All these Pavlovian dogs had been trained to do was short the stock and buy the bonds. That’s hedging? Bad doggies!

So now the dogs are howling. We’re seeing no end of news reports of unspecified “hedge-fund failures” and speculation about “systemic risk” at the banks and brokers who have lent them the money they use to leverage their losing positions.

These stories all seem to point to the same conclusion: The Fed must stop raising interest rates, or the new hedge funds will continue to get squeezed and pretty soon there will be a big crisis like the failure of Long Term Capital Management in 1998.

Well, friends, that’s nothing but lobbying. Sure, the new hedge funds want low interest rates so their bond positions won’t collapse on them and their borrowing costs will stay low. Right, and people in hell want ice water, too.

Should they get their ice water? No. It’s their own fault that they’ve taken stupid risks that depended on rates staying low. If their speculations are wrong, they’ll have to lose money and take it like men, just like anyone else.

The real risk is that the Fed gives in to their whining, and by slowing down their rate-hiking exercise lets inflation get out of control. So my advice to Greenspan is to call the bluff of the new hedge-fund geniuses. If they’re threatening to blow up unless they get lower interest rates, he should just steal a line from Dirty Harry: “Make my day.”

So if my clients are right, and the best trade is to do the opposite of whatever the new hedge-fund geniuses are doing, what would that be? Easy. Sell bonds. Buy stocks. Rest. Repeat.

The above is an “Ahead of the Curve” column published May 27, 2005 on SmartMoney.com, where Luskin is a Contributing Editor.

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Don Luskin

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.