The Bonfire of the Hedgies

08/22/2007 12:00 am EST


John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger, president of Bollinger Capital Management, explains how hedge funds have been forced to shrink, adding fuel to the current correction.

The typical hedge fund [has] a program (usually systematized) of running money that beats their cost of funds-usually benchmarked by the return of a three-month Treasury bill-by a small but meaningful amount. They take that margin of excess performance and multiply it by borrowing a lot of money and putting it to work.

Typically these programs are expected to have little or no correlation with and less volatility than the stock market. Since they are running at a positive margin above their cost of funds, for each dollar they borrow they add a small but meaningful increment to the bottom line. If they borrow ten dollars for every dollar they have in the fund, they can up their return to a very nice number indeed and easily justify the performance fees they are charging.

[But] if the funds fail to roll over their loans when they are due, they have to return the borrowed funds and collapse the fund back to its original size. Reducing the size of a fund can be very costly, especially if the investments involved are illiquid. And of course such a reduction prevents the fund from earning the types of returns they need to stay in business.

We are convinced that a large part of the motive force of the recent correction was just such a downsizing by hedge funds, which feared a liquidity crisis spawned by the problems in the subprime arena.

With the deflation of the hedge funds comes a change in the "carry trade"-the process of borrowing in a low-yield currency (such as Japanese yen) to increase the positive margin your fund produces. With the reduction of hedge fund size came a consequent reduction in the carry trade, which had been substantially impacting exchange rates.

Treasury-bill rates are once again plunging. The result of this is a steeper yield curve and that is a good thing, because when the yield curve is steep the spread between [financial institutions'] cost of funds and what they earn on loans and investments is wide, and they are profitable.

Make no mistake: this is exactly what the Fed wants at this stage of the game. Note also that M2, the standard and most commonly quoted measure of money supply, is growing at a strong rate, 6.2%; that's the fastest rate since late 2003. (Not a bearish environment for stocks!)

Once again gold has failed to serve as a hedge in a time of financial turmoil. It seems that even in these times when it is so popular to look down upon or outright hate the US, the dollar and US Treasury bills still represent the ultimate safe haven.

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