Vol. 12, No. 2,873 - The American Reporter - April 12, 2006

Market Mover

by Mark Scheinbaum
American Reporter Correspondent
Angel Fire, N.M.

Printable version of this story

ANGEL FIRE, N.M. -- Being a natural worry wart I clucked my tongue repeatedly when both the self-sanctified New York Times, and tv stock broadcasts alerted investors and general consumers to the coming hedge fund train wreck.

As with many of the scare tactics to grab headlines, there are grains of truth to the fears. Because of the nature of the hedge fund industry itself, the grains might even mount up to silos of danger, but let's put first things first.

Hedge funds are like risky, very sophisticated, often computer-driven mutual funds originally designed for the super wealthy who were ready and willing to take more risk for more rewards. In the early 1990s a hedge fund needed 40, 50, or even 75 percent returns per year to be a "player" and attract more millionaire clients. The funds were largely unregulated and extremely restrictive as to if, or when, you were allowed to pull out your money.

The New York Times report worried that as more airlines, auto makers, and Enron-style frauds are creating weaker retirement accounts, the government and the taxpayers bear a larger bail-out burden. When pension managers need a "home run" to make up for years of negative returns or only modest gains, they tend to hand off money to managers whose track records and personnel have spotty records and/or employ riskier investment strategies.

Let's point out that similar concerns were raised two or even three generations ago when trust companies and insurance companies started investing in real estate developments; marinas and resorts; cattle ranches, jojoba bean plantations; oil and gas limited partnerships; rail car and airline leasing deals; shrimp aquaculture in Central America; and gigantic office complexes along the Thames in London. All new and innovative investments raise eyebrows. Sometimes they become bedrock core holdings, such as real estate, and sometimes they lose money and fade away. Thus, the concept of a super-mutual fund with lots of transactions, commissions, short-selling and so forth is not bad or good per se.

The reports on CNBC-TV and Bloomberg Television a few days after the Times story echoed reports that some pension fund managers are heavily speculating in the "junk" or even "defaulted" fixed income instruments (another name for bonds) of distressed companies. If true, this story would involve criminal activities which make the usual insider trading cases amateur night at the opera.

The charge, as I understand it, works like this:

Day traders, speculators, hedge fund managers, and your grandma would like to really and truly know what the boardroom moguls at GM or Delta Air Lines are thinking as they fire people, renegotiate with unions, and put a positive face on negative things. Unless an individual or financial institution takes a reportable (large percentage) position in a stock under SEC rules, it is unlikely they will ever get a seat on the board. Individual stock analysts are required to meet with officers and talk with them on a regular basis, but, well, the information they report and numbers they crunch are only as good as the honesty of the folks giving them the numbers.

But, ahhh, along come bonds and their credit ratings. If a hedge fund buys $100 million or $1 billion in XYZ bonds at a distressed 45 cents on the dollar on negative news, and starts touting the bonds as "undervalued" or a "turnaround" candidate (boosting prices to 60 or 70 cents), the regulatory areas are a bit grayer than with a stock.

Add to this the smart lawyers hovering around injured companies like vultures above roadkill and even the biggest corporations can be forced to reveal very detailed credit information. To the reputable reporting agencies such as Standard & Poor's, Moody's, Fitch Ratings and others, this is the kind of information which sets a firm's credit rating. Good or bad ratings influence bond prices. Savvy hedge fund managers demanding access to the same information - which by all rights should be public information - are in effect using the back door to learn lots and lots about the "underlying" value of a company.

In layman's terms, when you buy a bond, you are buying the borrowing power and repayment ability of the "underlying stock." That's a fancy term for the common stock which could and sometimes would be manipulated to make companies look weaker or stronger. Keep in mind that when Enron or Kmart or Worldcom go belly-up, the bondholders might get a few cents on the dollar in a "workout" but the common stockholders almost always get nothing.

So what's a worker with a pension, or a small investor supposed to do when he or she hears money managers are investing their retirement money in hedge funds?

It's good to sound an alarm, but better to have the pension managers and board of trustees controlling the pension investigate each hedge fund on a case-by-case basis.

One danger sign would be a recent trend in which brokerage firms and other institutions are forming sub-accounts of existing hedge funds with a minimum investment requirement of $25,000 or even $10,000. It raises the red flag: "Should someone who only has $10,000 to invest be subjected to the volatility of something which is not prudent, suitable, or investment-grade for the customer?"

As a final hedge-fund caveat, take a more familiar theme: sector funds.

Going back to the late 19th and early 20th Century, the famous names in mutual funds had one and only one "Plain Jane" fund, which usually carried their name and the article of speech "the" preceding its name.

"The" George Putnam Fund; Delaware Fund; Fidelity Fund; Seligman Fund; Dreyfus Fund; Axe-Houghton Fund; Massachusetts Financial Fund, and so forth, allowed people with ten dollars or $100 to share top market expertise.

The fund manager might have 10 percent in mining, and 30 percent in retail, and 15 per cent in railroads, and so forth.

As market conditions changed, and transportation revenues increased, in a few months the manager might change the allocations of the "sectors" to reflect 7 percent mining, 25 percent retail; 35 percent railroads; 12 percent pharmaceuticals, and so on.

It was only as millions of working-class Americans read more financial newspapers and magazines, self-help investment books and money-management tv and radio programs boomed, and funds expanded into "families" and "groups" that people tried to cherry-pick last month's favorite "sector."

While a Fidelity Equity-Income Fund, or the old Delaware Decatur Fund, might over-weight energy or forestry stocks, or lighten up on retail and computer stocks, the officers of the "family" kept rolling out more and more funds which allowed even uneducated investors to play the auto, health care, banking, gold, Asia, or insurance "sectors."

I've seen no evidence that most people trying to perform their own sector transfers and "time" the market do any better than the original "Plain Jane" managers who took care of your sectors under one umbrella. Many individual investors actually lose lots of money trying to play each sector. Professionals on Wall Street joke that when Money Magazine, or Barron's writes up a hot fund or sector, the smart money has already cashed in their chips.

For hedge funds, the current fad will fade from thousands of funds to perhaps dozens. When enough widows and pensioners lose their shirts there will be tighter rules and investigations. I predict the first round of investigations will involve "short selling," which most mutual funds cannot legally perform. This is when you borrow stock you don't own so you can sell it, hoping to purchase it back in a "closing transaction" as soon as possible to chalk up a gain. Why "as soon as possible?" Because speculators leverage their money through margin accounts, and money is time. The longer they hold a position, the more they owe the brokerage firms.

Don't be surprised if the first cracks in tumbling walls come from the dirty little secret known all over Wall Street: traders who short large blocks of stock often never even make the required call to confirm, or then document that the stock "shorted" is even available to be borrowed. It only takes one stock "halted" by the exchange in the middle of the trading day to find out that crooked traders or hedge-fund managers have "borrowed" more shares than exist, hoping to replace them by the end of the trading day. What happens if because of hurricane, fires, terrorist attack, or bad news, trading is stopped for an hour, or a day, or a week?

At that point the dishonest hedge fund managers will be trading names of lawyers, not stocks and bonds.

Copyright 2006 Joe Shea The American Reporter. All Rights Reserved.

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