Rising Hedge Fund Count, Limping Stocks

Though the title of this piece would perhaps suggest a dislike of hedge funds, nothing could be further from the truth. If hedge funds didn't exist, we'd have to invent them.

They're essential to a smoothly functioning economy for the traders in their employ endlessly searching for market mispricings to fix through the commitment of capital. Price signals tell those with capital where investment is and is not needed, and as hedge funds correct what's not right in markets, their existence ensures that less capital is destroyed on a daily basis.

And while commentators who should know better have decried the billions that hedge fund trader John Paulson made in exposing the mortgage folly on the alleged backs of hapless homeowners, Paulson did the U.S. economy a great service in making his fortune. Indeed, in exposing major lending error early, the information wrought by his stupendous gains signaled to market actors that further investment in the housing sector was a fool's errand, thus saving a great deal more of capital from being destroyed.  Considering our limping economy at the moment, what a shame our servants in Washington didn't let the correction that Paulson profited from play itself out.   

Still, a new book out entitled The Hedge Fund Mirage perhaps unwittingly explains why the modern proliferation of hedge funds has been a negative for the economy, and by extension, the stock markets. Put simply, poor economic and stock market times have made hedge funds more necessary than before, which on its own is a bad signal.

Specifically, the book's author notes that since 1998, assets under management at hedge funds have risen from $143 billion to $1,694 billion. In short, the smart money, from rich individual investors to endowments to flush pensions, has more and more moved its money into hedge funds offering total return over simple long exposure to stocks and bonds.

Explaining why the above numbers signal limping markets and tough economic times is simple. This massive inflow reveals that the brightest allocators of capital don't expect major rallies of the ‘80s and ‘90s variety, and because they don't they're more willing to pay 2/20 fees over the much smaller costs that come with investment in mutual funds, index funds or ETFs.

To put it more plainly, if an investor intuits consistently rising markets for many years, why pay hedge fund fees when exposure to a low cost index fund will achieve similar returns with greatly reduced costs? What investors are saying today, as evidenced by the rush to hedge funds, is that since they don't foresee bull markets on the way, better it is to move their money into investment vehicles where "total returns" can potentially be gained irrespective of the health of the stock markets overall.

Looking into explanations for the big jump since 1998, that's similarly easy. Though hollow minds would presume that hedge funds have sprung up precisely because the fees accrue to the partners of same, lost on the simple minds who make this argument is the basic truth that no one's putting a gun to investors' heads and forcing them into hedge funds. Instead, it's voluntary and with good reason.

Specifically, during periods of extreme dollar weakness as we've witnessed over the last 10 years, stock markets necessarily sag. Though it's said regularly in this column, it's worth repeating that when investors go long stocks, they're effectively buying future dollar income streams. So when policy tends toward dollar weakness, there's tautologically less of an incentive for investors to commit capital to the stock markets.

Of course that doesn't mean investors head to the sidelines. Instead, they seek other ways to make money, and as hedge funds can thrive every bit as much in down markets as up ones, they're a good place to hide out during aimless market episodes. The weak dollar and its negative market implications don't explain the rush to hedge funds in total, but it's a certain factor. Investors aren't fools, and if they could gain similar returns in an ETF, they certainly would.

Sadly, the depressed scenario doesn't end there. As evidenced by what a difficult, competitive environment hedge funds operate in, the ones that last (and even some that don't) necessarily attract some of the greatest minds in the world. Though they certainly do grand work in providing the economy with more efficient prices, there's an unseen aspect that's perhaps not touched on enough.

Indeed, how many of tomorrow's Microsofts, Intel's and Google's will the global economy lose for hedge funds luring so many talented minds away from technology, transportation and medicine? Taking nothing away from the essential work that traders do, ultimately they're mere facilitators in their allocation of capital toward productive economic pursuits. That being the case, assuming a better market environment that history says would almost certainly be authored by a stronger, more stable dollar, it seems a not insignificant amount of financial talent would migrate out of hedge funds and into the metaphysical economy of the mind.

So while hedge funds remain essential and we'd be much worse off without them, that they've grown so substantially in modern times is not a bullish sign. Instead, it tells us the smart money that drives the direction of most any market presumes that we're not yet on the verge of the next bull market.