This feature is part of our FREE daily Money Morning email. If you’d like to sign up, please click here: sign up for
Money Morning
.
The good times may be over for hedge funds.
US regulators are starting to get twitchy about the industry. Here in the UK, the Financial Services Authority has always been far more cautious, but in the US they’ve been pretty much allowed to get on with it.
But the growing value and influence of this less-than-transparent industry has increased fears that there may be risks stacking up behind the scenes that threaten the stability of the entire financial system.
And the recent plunge in value at hedge fund Amaranth Advisors, caused by an apparent failure to implement what credit ratings agency Standard & Poor’s described as “fairly standard risk management principles”, has shaken up regulators. The US financial watchdog, the Securities and Exchange Commission (SEC) has launched an investigation into the group.
And being the US, they don’t do things by halves. Even the FBI is getting in on the act…
The fall-out from Amaranth Advisors’ huge losses from betting on the natural gas market look set to have serious repercussions across the whole hedge fund industry.
Both the Securities and Exchange Commission and the FBI now have the industry firmly in their sights.
Chip Burrus, assistant director at the FBI said hedge funds are “an emerging threat because of the dollar value and the number of institutions actively taking a look at this. People that aren’t expecting to have this type of risky investment in their portfolio end up taking a bath.”
Mr Burrus is articulating the concern that, as Ambrose Evans-Pritchard says in The Telegraph, the hedge fund industry is “spreading too fast beyond its natural niche as a rich-man’s toy, luring small investors in to risky investments.” This fear has been highlighted by the fact that various pension funds, including that of 3M, which makes Post-It notes, had millions of dollars tied up in Amaranth.
The Federal Reserve is also increasingly hinting that regulatory powers over hedge funds may need to be increased. New York Fed chief Timothy Geithner has been a concerned voice for some time. He worries that rather than dissipating risk through the financial system, hedge funds and the derivatives market may be concentrating it in unexpected places.
The fact that the derivatives market has expanded so rapidly (its nominal value is close to $300 trillion) during what has been a period of extremely benign economic conditions means it has never been “stress-tested”. And now that the economic climate seems to be turning considerably less hospitable, the big worry is that all of the checks and balances that these ‘highly sophisticated’ investors are supposed to have in place might be nowhere near rigorous enough to stand up to some real turbulence in world markets.
There’s a lot of mystique surrounding hedge funds and derivatives, but the basics are actually pretty simple. Hedge funds pledge to make investors money regardless of market conditions. Using derivatives, they can bet on the future movements of various markets and securities. They can also borrow money to make these bets.
But as anyone who has ever dabbled in spread-betting knows, you don’t just risk your initial stake – you can also lose a lot more if the market moves against you. And if you’ve borrowed the money in the first place, you’re in even more trouble.
Now it’s one thing for you or I to lose all our money spread-betting – but if a hedge fund loses all its money, that’s quite another. As John Paul Getty famously put it: “If you owe the bank $100, that’s your problem. If you owe the bank $100m, that’s the bank’s problem.”
This, in a very simplified nutshell, is what everyone is worried about. The European Central Bank recently warned that more and more hedge funds are adopting similar strategies – in other words, lots of them are placing their bets in the same direction. That increases the risk that a single unexpected event could batter a series of funds and then have a domino effect that could lead all the way to one or more of the big banks.
So it’s probably a good thing that the regulators of the world are trying to get a better idea of just how much risk is tied up in the industry. Whether they can then actually do anything about it is another matter, of course.
MoneyWeek’s own Cris Sholto Heaton wrote an extensive piece about the derivatives market and the potential threat it poses to financial stability in a recent issue – just before the Amaranth fund blew up, in fact. Subscribers can click here to read the piece: The dangers of derivatives
If you’re not a subscriber yet, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.
Turning to the stock markets…
Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email.
A strong start on Wall Street propelled blue-chip stocks to finish near intra-day highs, with the FTSE 100 index closing 75 points higher at 5,873. The gains were led by building materials group Hanson which jumped nearly 7% on bid speculation. BSkyB was the biggest faller, after Deutsche Bank declared shares in the broadcaster overpriced. For a full market report, see: London market close
On the Continent, the Paris CAC-40 closed at 5,219, its highest level since May and a 73-point gain. In Frankfurt, stocks also closed higher, boosted by Wall Street gains and a stronger-than-expected Ifo business climate index. The DAX-30 closed 58 points higher, at 5,960.
Across the Atlantic, better-than-expected consumer confidence data cheered investors. The Dow Jones Industrial Average jumped 93 points to close at 11,669. The Nasdaq was 12 points higher, at 2,261. And the S&P 500 closed 9 points higher at 1,336.
The gains were echoed in Asia where the Nikkei 225 ended the day 390 points higher, at 15,947.
Crude oil was little changed this morning, last trading at $61.35 a barrel. In London, Brent spot was at $59.02.
After a volatile day’s trading, spot gold was last quoted at $590.80 in New York last night.
And in London this morning, homebuilder Barratt Developments Plc announced a 3.4% increase in full-year profit and welcomed ‘a robust performance in a competitive market’. However, second-half profit had fallen 4.5% as average selling prices dipped. CEO David Pretty said the latter was due to its concentration on cheaper units and state-funded housing. Incentives such as payment of legal fees had also hit profits.
And our two recommended articles for today…
The changing face of commodities
– As regular MoneyWeek readers will know, commodities have been an investment success story in recent years. However, Morgan Stanley economist Stephen Roach argues that, as they have become more popular, commodities have taken on the trappings of a financial asset, and that has weakened some of their traditional strengths as an investment. If you invest in commodities, you must read: The changing face of commodities
Why the US economy is more sickly than you think
– When America sneezes, the UK catches a cold, say John Robson and Mark Selsby of RH Asset Management. Hence the intense focus of economists around the world on the US housing bubble and consumer spending. And they believe that the US economy is very sickly at present. For a fresh insight into the issue, read: Why the US economy is more sickly than you think