How far the mighty hedge funds have fallen. A few years ago, everyone wanted to know if they could get in on one (only if you were wealthy and could put down between $250,000 and $1 million). Billions of dollars poured into hedge funds over the past five years, as wealthy investors looked for ways to increase the value of their investments. And their hedge fund managers obliged, using bucket-loads of leverage along with strategies that included short-selling, arbitrage, program trading and investing in derivatives.
Now, the good times are coming to an end. Financial Times reported this week that hedge funds are in the "grip of [a] vicious selling cycle." The reporter explained that the "problems in the sector have set in motion a vicious cycle in the markets as hedge funds sell holdings to return money to worried investors, triggering further price declines and prompting more withdrawals."
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How would you like to get a letter from your hedge fund manager that said: “There are no assurances that the wind-down process will have a positive effect on the value of the portfolio or that further losses will be avoided.” That's what the honchos at Highland Capital Management sent to its investors recently.
But what you read in the news today is actually old news – IF you have been reading Bob Prechter's Theorist. In May 2008, he accurately described the scope of the hedge fund leverage problem.
Excerpted from The Elliott Wave Theorist, May 2008
Hedge Funds: The Same Story as 1999-2000 but Bigger
The spectacle of hedge funds losing money has surprised investors who thought their managers were experts at investing and that their expertise would accrue to the providers of capital. Everyone seems shocked that “the smart money was not so smart.” But actually the fund operators are very smart. Making money for clients is certainly one of the goals of hedge-fund managers, but another goal—if not their primary goal—is to make money for themselves. Managers get paid a percentage of profits over fixed intervals, and they do not participate in losses. So, the clever thing to do is to leverage the clients’ money to the hilt, because two or three super-profitable years allow a manager to retire immensely wealthy. That’s what managers did, and for many of them it worked. It worked so well that they will never have to work again. It is the investors who were naïve, not the managers who were stupid.
One thing that bothered me from the start about the whole hedge-fund mania was the media’s cultivation of another misnomer. Hedge funds hedge; but these funds are entirely on the opposite end of the spectrum: as leveraged and vulnerable as you can get. … today’s so-called hedge funds should be called spec funds.
Investors in spec funds also seemed to believe that their managers would buy and sell as necessary in anticipating market conditions, as if they are smart traders. But they are not traders. They are buyers on leverage. There is hardly a trader among them. Traders go long and short and sometimes they go to cash, depending on their analytical outlook. Buyers just buy. Does this sound familiar? It should, because the spec-fund phenomenon since 2003 has been nothing but a beefed-up, more-leveraged version of the equally erroneously named “day-trader” phenomenon of 1999-2000.
If you want to see a chart that shows exactly how much of a bad haircut the hedge funds have taken over the past few months, take a look at this chart from a special report if The Elliott Wave Financial Forecast, called "End of the Mania Era."
Excerpted from "End of the Mania Era," a just-published (on Oct. 15) Special Report of The Elliott Wave Financial Forecast (available to EWFF subscribers now):
Refashioning Bull Market Tools
The Door Slams Shut on the Hedge Fund Game
It is truly amazing what can be accomplished in an atmosphere of unbridled belief. The mania fostered the creation of—and then electrified—all kinds of instruments that did its bullish bidding. One of the most important was the hedge fund. Month after month, The Elliott Wave Financial Forecast and The Elliott Wave Theorist discussed the leading role of these woefully misnamed financial pools. It was frequently argued that they could survive a down market because of their investment flexibility. But Bloomberg lists 20 different Hedge Fund Research indexes, and virtually every one looks the same as the composite shown here in Figure 21 [see chart]. So far, the index is down 20.5% from a July 2007 high.
The EWI Hedge Fund Enablers Index, which Elliott Wave International compiled to measure the aggregate value of the main lenders to hedge funds signals a much more dramatic decline. Per Figure 22 [Editor's note: Chart not shown.], the Enablers are down more than 75% and just took out their 2002 low. The trend in the number of its members is also instructive. With Bear Stearns wiped out, Merrill Lynch acquired and Lehman shares slated for extinction, the number of hedge-fund enabling banks is down by more than 37%. Bank of America, Citigroup, Goldman Sachs, J.P. Morgan and Morgan Stanley survive. Hedge funds are doing everything in their power to lock in investors. Some are even offering to reduce their fees “if investors agree to stay put.” But it won’t work. As the bear market presses lower, the hedge fund ranks will be decimated even more dramatically than the banks.
Looking for Tomorrow's Investment News Today? You need to focus on Elliott wave analysis, which can alert you to trends before they start playing out. Check out the latest special report of The Elliott Wave Financial Forecast.