from Follow the Money

I thought hedge funds were supposed to be hedged

May 24, 2006

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Financial Markets

... against market downturns. 

Wasn’t a key selling point of hedge funds that they could make money even when the (US) stock market was falling, unlike mutual funds?

Well, hedge funds may be hedged against a fall in the US stock markets, but it sure doesn’t seem like hedge funds were (fully) hedged against falls in the stock markets of many emerging economies.   Or jitters in commodity prices.

I fully realize hedge funds do a whole lot of different things these days, and that in many ways the name "hedge fund" doesn't tell you much about what a fund really does.  Hedge funds can do things mutual funds cann't do, but that doesn't mean that they all do the same thing.  Or are all fully hedged.  Directional macro bets aren't "hedged,"  and long-short funds are only hedged v. certain risks, not others.  Those betting on credit spreads are long credit risk, even if they have hedged their interest risk and so on.

But it sure seems like everyone in the 2 and 20 world was piling into to emerging market equities a while ago.   It was an easy way to make money.  Hedge funds following different strategies all seemed to be taking the same long position.  So I am not totally surprised a lot of funds have losses.

Hedging a long emerging economies position with a short on the S&P sort of works, but not entirely.  Sometimes emerging market fall more than other markets.   And I don't think many folks were long say Turkish banks and short the broader Turkish market, or long Brazilian mining companies and short the broader market.  Most bets were simply long Turkey or long Brazil.

Among my current worries: the temptation to make money (lots of it) by selling insurance against a more volatile world when volatility was falling may have been too great for some folks to resist.   Paul McCulley:

With policy makers removing sources of volatility risk from markets, actual volatility falls, which like gravity, pulls risk premiums – the market compensation for underwriting volatility – lower. More specifically, P/Es rise, term premiums narrow, credit spreads tighten, and implied volatilities in options fall.

As this process unfolds, the forward-looking return on risky assets falls, but their real time actual return is heady, as lower risk premiums are capitalized. This is a perfect prescription for bubbles.

Well said.  The real time return – not the forward looking compensation for taking risk - may have come to dominate too many (financial) decisions.  I am one of thosecurmudgeons who thinks a more unbalanced world will likely prove to be a more volatile world.  We will see.

Note: I edited a few paragraphs to try to clarify my intent.  I did not mean to imply all hedge funds are fully hedged against all risks.  I was trying to use a bit of irony.  I did mean to imply that a lot of funds following different strategies had lots of directional exposure to emerging market equities.  Folks who were long say Brazil were long Brazil and a lot of other emerging markets -- long the local equity market and long the currency.   The hedges (offsetting shorts) that didn't cost an arm and a leg were global hedges.   If I am way off base there, let me know!