Hedge Funds-Published May 2007

                 At the start of this decade there was around 4000 hedge funds world-wide.  At the beginning of 2005 there was nearly 7000. By May 2006 there was 8,100 hedge funds, double the number of mutual funds.  Today, there are over 9,100. Once the financial industry saw such a profitable gold mine via commissions, service fees, and profit sharing coupled with an unregulated environment, they all raced to jump in.   Last year there were two fund managers who earned over $1b and another 8 that received over $240m in pay. 

                 As a group they control an estimated $1.4t.  Including borrowing potential, the amount jumps to over $2t.  The world offers about 150 different investments.  There are the metal markets in London and various other commodity markets scattered across the globe,  most stock exchanges,   currencies, and government debt.  However, roughly  40 investments are liquid enough to allow for  large dollar volume trades on a regular basis.

                 Since there are too many hedge funds and not enough investments available they are now investing elsewhere.  The past year has seen many hedge funds throw stupid amounts at already over-valued real-estate.  The most famous deal to date was the purchase of  Equity Office Properties Trust by Blackstone for $39b, $31b of that being financed via debt. 

                 A strategy growing in popularity is the leveraged buyout (LBO).    Last year, $450b worth of public companies were purchased in the deals, up from $50b only seven years ago. In this scenario, borrowed money  is used to purchase a public company. In most cases the debt issued to purchase the company becomes senior to that outstanding.  As a result, the current bondholders end up taking a hit because the debt being used to acquire the company increases the debt service ratio of the organization and will ultimately lower the credit rating of the company.  

                BCE is the most recent high profile takeover target in Canada.    Investment bank and Hedge Fund operator Kohlberg Kravis Roberts, has shown an interest in buying a majority position in BCE for $40 a share.  While its shareholders are enjoying a nice capital gain on the news, many of its bondholders-representing about $7.5b of BCE’s $11.9b in long-term debt– have been hurt as their holdings have fallen by 10%-20% with spreads widening 300 basis points  above Canada’s 30 year bond.   This spread reflects the higher risk the current outstanding bonds would carry if the LBO firm rolled its takeover debt into BCE.  This will inevitably leave BCE debt holders  “ ...subject to higher risk, higher leverage and lower credit ratings,” according to Dominion Bond Rating Service.

                 In the process, the hedge fund pays itself a huge commission for arranging the deal.  Once the hedge fund collects its fees and bonuses, the purchased company declares a huge one-time dividend that  eliminates much of the company’s cash holdings by passing it onto the shareholders (the hedge fund).  With stock markets around the world doing well, the hedge fund, with help of Wall Street and Bay Street, will then take the company public again, at a higher price than what they paid in addition to passing the debt back to the average shareholder.  This strategy is the perfect legal pyramid scheme.

                  Hedge Funds are one of the main causes of  price inflation.  Forget about blaming China and India, they are responsible for exporting deflation via lower labor costs being passed onto the consumer.  By investing too large of sums into small markets such as many commodities, the hedge fund pushes up the price of the commodity which still must be used as an input into a value added process.  The company that must use the commodity is faced with higher input costs that will be passed onto either the consumer via higher prices, or the shareholders in the form of falling profits due to increasing input costs. 

                  There has yet to be a shortage of oil in the world, nor will there be for at least one hundred years.  It is interesting to point out that, as the number of hedge funds increased so did the price of oil.  Similarly, the price of gold has increased with the number of hedge funds as well.  If there was even half as many hedge funds, both would be roughly 50% below today's prices.  Copper is another metal that is trading far beyond fundamentals.  During May 2005, there was a shortage of above ground copper, as a result the price of the metal increased to $1.52 per pound.  Today, with supplies up over 300% and ample, the price is up 129% in London and up 122% in Chicago.  Gold, oil, financial instruments and copper are the most traded assets by the hedge funds. 

                  While there lacks any meaningful evidence, I am certain that the following strategy is also being practiced by some hedge funds.  Since it is impossible to track a metal once it is received by its buyer, it is possible for one to continue to buy a certain commodity and corner the market.

                  In 1973, the Hunt family of Texas, one of the richest families in America at the time, decided to buy precious metals as a hedge against inflation. The Hunts, together with some wealthy friends, formed a silver pool  and began to buy silver in enormous quantity. In a short period of time they had amassed more than 200 million ounces of silver, equivalent to half the world's deliverable supply.

                 When the Hunt's had begun accumulating silver in 1973 the price was in the $1.95 per ounce range.  By the early eighties the price  peaked at $50.50.  Typical of most investment manias, the retail investor joined the party at the peak.  Unfortunately,  changed trading rules on the Metals Market (COMEX) and the intervention by the Government put an end to the game.  Specifically, the price collapsed because the elite in Washington and on Wall Street started shorting silver in the low teens.  Meanwhile the Hunt clan rightfully called for delivery and the short sellers could not supply the silver.  Since the short sellers controlled the various government positions they easily changed the laws making it illegal to hold the metal.  As a result, the price began to slide causing a 50% one-day decline on March 27, 1980.  Silver plummeted from $21.62 to $10.80.  By 1987, the Hunt’s liabilities had grown to nearly $2.5 billion against assets of $1.5 billion.  Consequently, the Hunt brothers declared bankruptcy in addition to being convicted of conspiring to manipulate the market.  Unfortunately, the only mistake the Hunt clan made was not inviting both Wall Street and Washington to join into their lucrative plan.

                 At the start of the this decade it was believed many funds were making 20% or better.  However, no one knows for sure since no accurate reporting is done, let alone necessary.  It is mathematically impossible for all hedge funds to make their investor’s money. There are rumors that many funds are juicing up their performance.  Some are believed to be reporting profits today, based on future revenue and capital gains.  This is very easy to do.  Enron did the same thing only with gas and electricity futures.   Again we will never know what is happening since they are not made to disclose any financial information to anyone.  The latest numbers for 2006 show that hedge funds supposedly produced returns of 6.7% annually, on average.  If true, they did outperform many stock markets and real-estate, however, it is still not a stellar  record.

                 Because there are so many hedge funds with no shortage of money, we are in the midst of a new financial bubble.  Today’s actions, and the excesses they are creating, are exactly the same as in the late twenties and the late nineties. There are surpluses of most food.  We are overbuilding real-estate, vehicles, and many consumer goods, so, many asset prices today are unwarranted.  The bottom line is hedge funds are creating a huge world-wide financial bubble.  No one knows how much more it can expand.  We do know that one day it must revert to the norm in order for the economy to come into balance.  When this occurs it will aid in pushing the global economy into a multi-year recession.   At least half of all hedge funds will  disappear. Those left will be holding depreciating assets tied to huge debts. 

                 Under no circumstances can we afford to see house prices fall by more than 10% and/or stock markets fall more than 5%.  We cannot afford higher interest rates, yet the global trend is in place.  Stock markets cannot afford cheap oil, yet it will fall to below $40.  This is the longest period on record  without a true economic pullback.  The last occurred in the early eighties.

                 Hedge funds are popular, however, they are past their peak.  There are too many chasing the same thing and are now in the midst of the Greater Fools Theory.  This new segment of the global economy has not once been tested as a whole on the downside.  Since no accurate reporting is mandatory, when trouble comes, investors will be caught by surprise and will feel the pain after the fact.  Most investors will not be able to get out since most exercise a minimum holding period. Stay away from all hedge funds, they are about to disappoint many people.