Charles Gradante, managing principal of hedge fund advisors Hennessee Group, hit back fiercely today at critics of hedge fund investing. “Contrary to general opinion,” HE thundered, “hedge funds are not in control of this bear market, nor are they a bunch of `unregulated cowboys’ who are `talking down the market’ and `shorting companies into submission.'”
Gradante says several industry professionals have approached the Hennessee Group regarding the perception by the public and the investment community that “hedge funds are in control of this market” and “hedge funds present the next major threat.” He says reasonable estimates are that hedge funds account for 6% of the daily trading volume (occasionally 10%) and, through July 2002, are negative in performance (-4.73%; Source: Hennessee Hedge Fund Index). True, he continues, a handful are shorting this market and are profitable, but the vast majority of hedge funds are net long this market, which accounts for the overall negative performance. “Their performance alone suggests that it is highly unlikely hedge funds are in control of this market or a major threat,” says Gradante. “Those in the investment community who justify their own poor performance in the market by pinning the blame on hedge funds are myopic and cannot see the forest for the trees.”
With respect to volatility, hedge funds are a factor but certainly not the main cause of the intraday volatility that many in the investment community would have investors believe, says Gradante. One of the main causes for volatility in this market is program trading (institutional buy/sell programs), which accounts for 38% of the volume on the NYSE (Source: Barron’ s). The volume level and the electronic nature of program trading have caused sharp movements in the market. The institutions performing buy/sell programs are predominantly non-hedge funds. Many are, in fact, investment banks that are hedging their balance sheet risk.
The second, and probably the most important, consideration with respect to market volatility is the trading of financial contracts by futures managers (CTAs), particularly NASDAQ and S&P contracts. Many of these contracts have recently become electronic, which exacerbates the intensity of market swings.
“Futures managers are not hedge funds,” says Gradante. “They are regulated by the CFTC. Hedge funds are not regulated by any government agency. Perhaps the fact that CTAs are regulated and hedge funds are not has led many in the investment community to overlook futures managers and inadvertently point the finger at hedge funds for much of the irrational or unexplainable movements in this tumultuous market.”
Generally, financial futures managers have had positive performance for the 12 months ending July 2002 (+18% on average, some as high as 60%; Source: Barron’s), says Gradante. “So guess who is making money shorting this bear market? Not hedge funds. If anyone is moving this market to the downside and making money, it is CTAs. Most are momentum players and, consequently, have accentuated the volatility of this market. They are also directional players and, for the last 12 months, have had an overall negative bias with only intraday shifts in direction.”
The futures market and the underlying cash market reach parity at the expiration of the futures contract, explains Gradante. In this bear market, CTAs have been net short futures contracts, causing the cash market to follow. On an intraday basis, CTAs can go long and then short the futures market (or vice versa) adding to “real volatility.” NYSE specialists, who can step aside as stocks fall to their natural price support level because of a shortage of buyers, also account for much of the “gapping down” in stock prices – more so than short selling by hedge funds.
Finally, says Gradante, it is important to note that hedge funds were negligible in size during the 1980s and, therefore, irrelevant to the 1987 crash. However program trading, CTAs shorting financial futures, and specialists stepping aside (because of lack of buyers) had relevant impact to that crash. “Hedge funds certainly play a role in this market but not to the extent that many in the investment community would have investors believe,” says Gradante. “We need to consider all the players in this market, especially those that contributed to excessive volatility and exaggerated negative bias in prior bear markets.”
The Hennessee Group has been observing the investment community’s discussions of hedge funds since this bear market began, continues Gradante. “It is obvious to Hennessee that the view of the investment community and public opinion is something short of positive,” he says. “A `lynch-mob’ mentality appears to be snowballing. Internet `chat rooms’ and investment professionals interviewed by the media are quick to pin the blame for the funk in this market on hedge funds. At first, the negative view of hedge funds in the investment community was benign and somewhat amusing. Now we have reason to believe that an avalanche of negative sentiment toward hedge funds has begun. This is untimely since Congress and the SEC are performing a review of the industry. This review is essential and appropriate for the industry to set the record straight and weed out any abuses. It need not be misguided by the good-intentioned but misinformed members of the investment community. As an advocate, we feel that it is in the best interest of the hedge fund industry to inform our brethren in the investment community of their misconceptions about our industry. Hedge funds are not the cause for the intensity of this bear market. It is too easy to blame the `new kid on the block’ for the decline in real estate values. As briefly alluded to before, there are many complex issues related to the direction and volatility of this bear market. To pin the blame for the vagaries of this market on hedge funds is ill-informed and undernourished.”
“Lastly,” says Gradante, “many in the investment community would have you believe the hedge fund industry is riddled with `unregulated cowboys’ that are `talking down the market,’ `shorting companies into submission,’ and `full of conflicts,’ as well as `con artists.’ Certainly we have had some bad apples, but these should not define an industry that is fundamentally good.”