Today’s financial markets have shown considerable volatility that’s likely to unnerve many private investors. Much of the reason for it comes from the changing character of the economy due to the massive amount of government stimulus stemming from the pandemic. As this stimulus winds down in the face of inflation, financial markets have been shifting away from riskier assets to those that are more stable. Hedge funds more than any other investing group have driven a large amount of this volatility.
Hedge Fund Defined: A hedge fund is an actively managed investment pool that utilizes a variety of different strategies that seek to generate above average returns for their client investors. These strategies include, but are not limited to, short selling, buying on margin, trading commodities, futures, options, other derivatives, that advance in the opposite direction of the fund’s main focus. Many hedge funds will invest up to 130% of the total amount of money sent in by their clients. This would mean that as much as 30% of their total investment pool is borrowed from one source or another. Their risk status is generally very high, and their minimum threshold to buy into is high enough to exclude all but wealthy investors. Further, there may be some limitation or restriction on the amount and/or timing of withdrawals. Generally speaking, hedge fund managers have wide latitude as to what strategy to employ, and when. The fees are higher than other mutual funds, and the rewards are greater thereby attracting some of the top talent in the entire industry.
On the Cutting Edge: Owing to the amount of leverage that hedge fund managers have at their disposal, sudden changes in the economy or dramatic financial news can cause the hedge fund to automatically react and force trading. As the size of their trades can be large, this in itself could cause a turn in momentum in either direction. Momentum can then expand the amount of overall trading that, in turn, will move stock market indices. For example, if the Federal Reserve were to announce an end to their buying of mortgage backed securities, this might result in large hedge funds deciding to sell off or short the stocks of shadow banks and other financial companies that specialize in investing in mortgage backed securities. This sudden move could force other investors to sell declining financial company stocks causing the entire sector to decline. A few days later, other hedge funds might decide in a different paradigm to buy the dip in these same financial stocks and drive the prices right back up again. Financial markets have seen quite a lot of this whipsawing of prices taking place in recent years, a lot of which can be attributable to hedge fund activity.
Thinking in the Short Term: Many investors think over a five-year or longer horizon when they make investment decisions, buying and holding an investment until it reaches the end of its productive use. Hedge Fund managers might look at the same investing criteria, but over a much shorter investing horizon that is measured in weeks or even days. Hedge fund managers will have the same fundamental and technical information at their disposal available to most investors, but they often take it a step further by seeking out other auxiliary or esoteric information that might impact an investment or a trade. Such information might be: is a corporate CFO confident that the quarterly forecasts will be attained; are major investors jittery about swings in the price of the company’s stock; would a bad news report cause a sell off; will a merger with another company take place, will the union go on strike, etc. When discussing potential investments with other industry workers, a hedge fund manager might be more interested in down playing the value of a particular stock in order to invite selling by his colleagues, thereby driving the price lower for him to buy in. Very few hedge fund managers are unconcerned with short-term shifts in stock prices.
Conclusions: Hedge funds date back to the late 1940’s. During the boom years in the 1960’s the concept worked really well, but it became unpopular with the recession of 1973/4, and many hedge funds shut down. The hay days of the 1990’s saw a resurgence of hedge funds that again faded with the dot-com bust in 2002 and the financial crisis of 2007/8. They have rallied once more recently with about $3.6 trillion in assets under management in 2019. It’s all about high stakes, high rewards that seek to beat the markets to get even higher returns. But like many investment systems, they can suffer just as dramatically during a downturn.
Sources: Investopedia.com, Hedge Fund.
The Economist, Sexagenarians and the City, by Buttonwood, January 15, 2022.
Is there not some new laws that slow down the speed at which hedge funds and day traders can act?
Very few that I know of. I did some day trading for a while, and my broker sent me an email telling me I qualified as an active trader and had to maintain a certain cash balance in my account. Beyond that there might be other laws for hedge funds, but I’m just unaware of them.