Echoes of 1998

When GM bonds skidded last week, a few hedge fund managers ended up with tire tracks across their backs…and some nasty injuries.

According to the hyperactive Wall Street rumor mill, several large hedge funds are reeling from an ill-timed “capital-structure arbitrage” play: Buy General Motors bonds and simultaneously sell short the stock. We’ll review the particulars of this disastrous trade in a moment. But suffice to say that neither side of this arbitrage behaved as anticipated, which caused a few big hedge funds to suffer great, big losses.

If a few big hedge funds are in trouble, as CNBC’s Maria Bartiromo has been breathlessly reporting, are a lot of us little investors also in trouble?

Maybe so, but we have already been living in a state of perpetual peril for many years, thanks partly to the growing influence of hedge funds in the global financial markets. In other words, the GM debacle may have triggered a financial “red alert,” but “orange alerts” have become a near-permanent condition…And that’s both bad and good. Although the growing influence of hedge funds within the financial markets creates unnerving volatility, it also creates unique opportunity…

But first, let’s take a look at the latest “red alert” on Wall Street, stemming from wrong-way bets on GM securities. Many hedge funds had been loading up on General Motors bonds in recent weeks, while simultaneously selling short GM stock. “Their wager was that GM would limp along and be able to make the interest payments on its bonds,” the Wall Street Journal explains, “but that the continuing challenges to the giant automaker would keep a lid on its shares.”

The gamble may have seemed reasonable, but it produced disastrous results when both sides of the trade “blew-out” in the wrong direction. First, the stock spiked when Kirk Kerkorian offered to raise his stake in GM to about 9%. Next, GM bonds plummeted on word that Standard and Poor’s had slashed the automaker’s credit rating to “junk” status.
Because the GM stock-bond trade had seemed relatively tame, and because of the vast quantities of GM securities outstanding, we have no trouble imagining that many funds had crowded into a version of this trade. But are the resulting losses so large and so widespread as to be destabilizing to the global financial markets?

Probably not…but maybe so. Most likely, the GM debacle is something more than a non-event, but something less than a disastrous event. For perspective, let’s consider a worst-case scenario.

A few weeks before the infamous “blow-up” of the Long Term Capital Management (LTCM) hedge fund in 1998, the S&P 500 Index traded near 1,200. Shortly after the LTCM crisis hit, the S&P tumbled to 923, or more than 20% below its then-recent high. Similarly, on March 7th of this year, the S&P 500 traded a few points above the 1,200 level. If past were prologue, therefore, a second LTCM-style crisis could plunge the S&P below 1,000. Very few investors would enjoy that ride.

We would not rule out the possibility of a repeat, but we would assign a low probability to that outcome. Of greater concern is the growth of the hedge fund industry itself. There is nothing necessarily wrong with hedge funds, per se. Some of our best friends are hedge fund managers. But it is possible to have too much of a good thing. Van Hedge Fund Advisors estimates that there are about 8,500 hedge funds with about $900 billion in assets – twice as many as existed 5 years ago.

The parabolic growth of hedge funds over the last few years has introduced new – and often exotic strains of both risk and opportunity into the global financial market organism. As such, we individual investors should remain vigilant for both.

Hedge funds have become an outsized influence in the financial markets. In many respects they ARE the financial market. Last year, for example, hedge funds accounted for about 82 percent of the trading volume in the U.S. distressed debt markets and 70 percent of U.S. trading in exchange-traded funds. The funds also account for more than one quarter of all the volume on the NYSE. In short, they are everywhere.

In the early days of hedge funds, the pioneers tried to take advantage of stock market inefficiencies. But today, hedge funds often CREATE the inefficiencies because they often flock to similar strategies and trades. From time to time, therefore, certain pockets of the financial markets become cluttered with hedge fund managers jockeying for a competitive edge. In those moments, certain market sectors or asset classes can become irrational, volatile and frustrating to individual investors who utilize fundamentals-based investment strategies.

Our advice: don’t get mad, get ready.

We should remember that the very same volatility that injects risk into the markets also creates opportunity. While it’s true, for example, that the S&P 500 hit a low of 923 in the wake of the LTCM crisis, the S&P soared to more than 1,400 a few months later – a gain of more than 60%. In other words, the LTCM disaster contained the seeds of opportunity.

The Long Term Capital Management disaster of 1998 illustrated the infinite capacity of “smart guys” to do dumb things. (Having Nobel Prize winner on the payroll – as did LTCM – may be helpful for structuring hedge-fund-destroying arbitrage trades, but it is not an absolute prerequisite). If, therefore, a few brainiacs in Greenwich, Connecticut can cause a serious financial crisis, just imagine what 8,500 brainiacs could do.

In short, hedge fund managers, as a group, are no so different from most other groups of investors. As individuals, the managers may be brilliant – or not – but as a mob, they can be complete idiots. And when they are idiots, they can create opportunities for us individuals.
Returning to our central query, therefore, if some big funds are reeling, are we little guys in harm’s way? Maybe, but we are also in opportunity’s way…So why not be vigilant for both?