Hedge Funds Headed for Same Fate as Day Traders – But Bigger

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Hedge Funds Headed for Same Fate as Day Traders – But Bigger

By Susan C. Walker
Wed, 21 May 2008 11:00:00 ET

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The credit crisis has managed to prune the hedge fund industry, but the most severe cuts are yet to come, says Bob Prechter.

The credit crisis first revealed itself in June 2007 when Bear Stearns had to bail out one of its hedge funds. And then this March, as it looked like Bear Stearns might have to declare bankruptcy over its collateralized debt obligations going bad, the Federal Reserve came to the rescue and helped JP Morgan to buy the Wall Street investment bank.

A story in Bloomberg (Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults, May 20, 2008) explains that one hedge fund adviser was getting plenty of nervous calls that Friday, March 14, from his hedge-fund clients. They wanted to know whether they should buy credit-default swaps (CDSs), a kind of derivative that could offer them some protection if Bear Stearns were to go under. His answer: the price of the CDSs was going up exponentially and if Bear went under, it might take other banks with it, including the ones issuing the CDSs.

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Everyone dodged the bullet that day thanks to the Fed's action, but the danger of a credit-default swap debacle still lurks, because it is a huge market – larger than the dollar value of the NYSE – and it is unregulated. As the Bloomberg story goes on to explain:

"Unlike with traditional insurance, no agency monitors the seller of a swap contract to be certain it has the money to cover debt defaults. In addition, swap buyers don't need to actually own the asset they want to protect. It's as if many investors could buy insurance on the same multimillion-dollar home they didn't own and then collect on its full value if the house burned down."

While a failure in the swaps market could crush many hedge funds that deal in them, Elliott Wave International's Bob Prechter sees an even more basic reason why they will ultimately come to a bad end – that's because they're not really hedgers, they are merely buyers. Here's an excerpt from his most recent Elliott Wave Theorist that explains why hedge funds are facing an even bigger problem than day traders faced in 1999 and 2000.

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[Excerpted from The Elliott Wave Theorist, May 2008 edition]

"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. The term 'hedge fund' so egregiously mis-applied is like what happened to another useful, venerable and previously accurate term in the early 2000s. That’s when the media foisted the term 'market timer' on people who cheated the market by back-stamping the times of trades. Market timers and hedge funds used to be considered practitioners of decent professions. Now the terms are used for people who run—or are perceived as running—scams. The ticket back-daters should be called frauds, and 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. Back then, mild corrections in the stock market in 1999 and 2000 decimated these so-called traders who were really just buyers. Here is what EWT said about it at the time, in response to some claims in an article:

The word 'trader' is bandied about these days as if it meant something other than 'buyer.' A buyer is not a trader. Stocks such as America Online and UBid that move down 29% or 82% should be 'darlings of day traders.' Those are huge moves; their direction is irrelevant. An actual trader could make money from them. But a buyer cannot. 'A former can’t-lose day trader' in this context means a former couldn’t-lose bull. The very idea that the novice legion buying Internet or any other stocks are traders is ludicrous. They are bullish maniacs, caught up in the mania. The proof is that a measly 6% pullback in the Dow can ruin them. –The Elliott Wave Financial Forecast, July 1999

"Just as small corrections erased the profits of the “day-traders” of nine and ten years ago, all it took was a slide in the extreme fringes of the debt market to wreak havoc on leveraged funds’ profits. And it has happened for the same reason: They are simply one-sided buyers, and the market finally reminded investors in these funds that TANSTAAFL." [Editor's note: TANSTAAFL = There ain't no such thing as a free lunch.]

Tags: hedge funds, credit crisis, credit default swaps, Bear Stearns

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