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Hedge funds in the gun

By Neville Bennett

Friday 4th April 2003

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Last Monday was terrible: it was the day of many settlements in financial markets and marked the final loss of wealth. Investors who took positions after January 1 retained a modicum of hope that their "ship will come home" ­ right up to the closing bell.

After the bell tolls, they have to settle and then address the serious tasks of writing their accounts in the red or black ink.

Talk about the first quarter is many-layered. There is the important "retail" of investors in shares, commodities and fixed interest.

There is big money in these main markets but the futures market may be more important. It swamps the physical market and like a huge build up of snow it is ready to avalanche down on to the physical markets.

Retail investors will have noted a surge in US markets when the war against Saddam began. Those who really understood markets would adjust their screens to the futures markets to see what was really happening.

The conclusion to be drawn is that of a rort. Dealers are convinced a "plunge protection team" stimulated the markets by pouring in a trillion dollars and were joined by some investors who didn't wish to miss a rally. Mutual funds sat on their hands.

The rally caught some hedge funds in a difficult position. Most have taken a bearish attitude and vast amounts of money have been staked on a fall in shares.

Hedge funds were in a spot. They had to respond by buying shares ­ a process called "short covering." A few years ago hedge funds were small potatoes, certainly only for the rich.

There are now 7000 hedge funds in the US and their assets have grown to an estimated $US600 billion. They are mainly involved in fixed interest and currency markets rather than equities.

They are not enormously profitable. Indeed, last year their average return was 0.2% but this was miles better that the average diversified equity mutual fund that lost 22.4%. Over the last three years, the average return by hedge funds has been 11.25% while mutual funds have lost 11.7% a year.

Hedge funds have made money by betting against the equity market. Many US authorities have argued there should be a law against their predominant practice of "short selling." (See C Meyer in "Why fear hedge funds" at www.mises.org.)

Hedge funds had been driving the market down until the hot war brought a rise. The number of shares traded rose to 1.7 billion, above the average per day in 2002 of 1.44 billion. Prices rose and fell. These are perhaps the most volatile days in history. Average volatility on the CBOE index in the period 1986-2002 was an index of 21.56. In mid-March the average was 35.68.

The Dow Jones' rise caught the hedge funds off balance. They had shorted the market ­ that is, sold shares they didn't possess in the hope of buying them cheaper later in the month.

The index's the largest rise in 20 years threatened to break the hedge funds that had contacts for short-term short selling. Their only damage control was to buy shares as soon as possible.

They had sold shares they did not possess. When the sharemarket rose, the hedge funds "covered" their position by buying the appreciating shares. There was a ratchet also working in the "short-covering," causing the Dow Jones to overshoot.

US authorities are trying to legislate against "short-selling," for it seems to bring shares down. This is rather selective for the authorities have never minded those people who talk the market up ­ such as the "Wall Street analysts" who have confidently spoken about the Dow at 15,000 (rather than its current 8000).

It is not only hedge funds that are shorting the market. Many Wall Street brokers are urging clients to avoid bonds (which are in a bubble situation) and play the equity market by selling puts and buying calls.

A put contract allows the buyer the right to sell a specified share within a certain period. The contract is purchased in the expectation of lower prices. A call contract gives the buyer the right to purchase something within a specified time limit. Much money is betting that the market will go down.

Present day markets are extremely turbulent. It is a cautionary tale that a sudden bull market in mid-March can turn to custard. If ever investors needed educating, as last week indicated, a cakewalk could turn into a quagmire.

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