28JAN09:
Q1-09 DOW: 8900
Q2-09 DOW: 7250
Q3-09 DOW: 5810
Q4-09 DOW: 3960
CITI NATIONALIZED
OBAMA GETS SICK 27AUG09:
Mini Crash 21SEP09 Predicted correctly:
Bailout=Bonuses
Demise of Bear Stearns
Demise of Lehman Bros.
Demise of AIG
Subprime would cause problems
Date of 2007 crash
CRAs were to blame
G20 riots were a party
Northern Rock run
Northern Rock Nationalization
HBOS and RBS demise
UBS really was Useless
Yesterday I looked at revamping the tired logo of FiNTAG.
Using the same agency as the 2012 London Olympics I was looking forward to a new logo that would appeal to the "google generation", but have to report that the negative feedback has been shocking. Sometimes it is best not to move on but stay where you as everything comes back again anyway.
Today Citi moves into action, Hedgies start reading their ISDAs in more detail and copper and tin is more fun that a night at Scores. Germany, Japan and lots of news from reuters fill the rest of the space in a somewhat dank and dull day of Hedge Fund news. I am sure the G8 will soon sort this out.
An Apocalyptic Turn for Hedge Funds? (hedgeworld) The times are challenging for the hedge fund industry. Aside from being consistently attacked in the media by critics, the industry now suffers from industry leaders prophesying an end to the industry. I argue, conversely, that the hedge fund industry is infinite.
Early in January 2007, George Soros said that hedge funds have become too popular. Steve Cohen, founder of SAC Capital Management LP, meanwhile maintains that the days of big returns for hedge funds are already over. Warren Buffett, in his annual letter to shareholders released at the end of February, criticized hedge funds for their high fees.
My opinion is that, while it cannot be denied that the industry did not deliver the expected performance in the past few years, it is still far from taking an apocalyptic turn toward extinction. I still maintain that hedge funds are a very imperative diversification component in any investment portfolio, and that it will still be that way in the years to come.
Like any other investment instrument domain, there are good managers and bad managers in hedge funds. But within this industry there also exist new emerging managers, new emerging strategies, and new regulations, all of which are pointing to a sustainable future for the industry.
Current facts support this positive outlook. It was reported by Hedge Fund Research Inc. that in the first quarter of 2007 alone, the hedge fund industry attracted $60 billion from global investors. Because of this new record, it is estimated that the hedge fund industry has already managed, in total, a little below $1.6 trillion in approximately 57 years of existence; compare this to mutual fund industry which has grown to manage a total of $22 trillion, from the mid-1800s up to the present.
Fifteen years ago, the industry was composed of roughly 500 managers and around $40 billion in assets. Today, there are more than 10,000 hedge funds. Not all managers are qualified enough to manage a hedge fund vehicle, and these have resulted in negative outcomes. Nonetheless, from a historical, technical, and practical point of view, the industry still has a lot more room to grow and to perform.
In previous articles I discussed the hedge fund life cycle Previous HedgeWorld Story. Looking at the Credit Suisse-Tremont Hedge Fund Index, it is very likely that not only do hedge funds have a life cycle, hedge fund strategies—at least the core ones—are likely to have the same motion.
These are indeed challenging times for many hedge fund managers and hedge fund strategies.
Compared to 10 years ago, many strategies are struggling to perform lately. What I see is too many managers chasing the same exotic and limited markets. Many hedge fund strategies that only a few years ago had few managers and controlled assets flows are now super-sized and chased after by too many players. Thus, bigger managers are challenged in their diversification, risk and execution management as capacity becomes an issue.
While disputing some of the industry gurus, I do feel that their claims are, to a certain degree, shortsighted, not taking into account the big picture.
The bigger and more reflective picture is that as a rather young industry with a moderate global market share, the hedge fund industry has a bright future ahead. While some of the core strategies may become outdated, new ones are now emerging, allowing more room for new players.
Since hedge funds are designed to take advantage of any possible market and opportunities, hedge fund managers will have to show the required creativity and capability to structure interesting and exotic vehicles. Thankfully, hedge fund managers have historically proven themselves to be creative and capable. Wherever money and wealth could be created, investors are likely to find hedge fund managers taking charge. The new emerging and innovative generation in the industry is already creating new hedge fund vehicles and strategies.
Earlier in 2007, Paramount Vantage and Morgan Stanley announced the creation of the Marathon Funding LLC, a $150 million film fund that will invest in film production. Toward the end of 2006, two hedge funds in the United Kingdom created a fund that buys stakes in the contracts of younger athletes, then takes a slice of the transfer fees that clubs pay to trade the players.
I believe that newer hedge fund managers and strategies will be available in the future. Smaller niche funds will also emerge, such as music-recording funds, funds that search for talented students, space travel-financing funds, book writer-financing funds, warehouse-financing funds, lawsuit-financing funds, and art and antique funds, among others.
I predict that the future in this industry will also allow personal hedge fund pools to be created, where private investors will manage their own hedge fund instruments. I also believe that there will also be room for tailored managed funds whereby fund managers will open private hedge funds.
We are at the beginning of a new era in the hedge fund industry, and I seriously challenge more managers to overcome the psychological barrier in setting up a fund, and to come out with new strategies.
It is my view that this is not at all the end of the hedge fund industry. Mr. Soros, Mr. Cohen and Mr. Buffet may be somewhat gloomy, and their comments may result in a tougher environment for hedge fund managers where more regulations are introduced, causing a decrease in number of managers.
But we will only see the industry further growing, changing, and attracting more managers, strategies and investors. Yes, it is inevitable for new hedge fund strategies to get overexposed along the way. But that will just result in the maturing of those strategies, and new strategies slowly emerging. The core strategies will clear the way to new ones, resulting in an infinite future.
Fintag says People are stupid.
Hedge Funds are just the Proprietary Trading Desks of old. Banks have always traded their own balance sheet to make money and Hedge Funds popped up because the banks weren't paying its marketers and traders enough and more importantly the barriers to entry were low enough that traders could trade outside the cosy environment of a corporate bank. Personally I think it all happened with the rise of the internet because before then you had to use an infrastructure that only banks could afford to build and maintain. Once you could email trade instructions and get back confirmations, you were on your way.
The move, which was unveiled in an internal memo last week, comes after years during which Citi has lost ground to rivals in serving the hedge fund industry. It involves the creation of new coverage areas and a management reshuffle.
Citi has been refocusing group businesses over the past six months in an effort to cut costs and boost revenues in markets where it is lagging rivals.
Last December the bank created its fixed-income, currencies and commodities division to better align the various businesses with the needs of clients. The global sales restructuring is a direct extension of the move to create the FICC division.
A banker said: “Over the past three years we have been increasing our focus on providing capital raising to big macro risk-takers. The structure is now in place.”
According to the memo, London-based Antonio Cacorino and Mike Mauer, co-heads of global investor sales, have created three new divisions. The first is called the hedge fund strategic capital coverage group, one of the most important businesses of a “strategic growth area” for the bank.
Sara McKerihan, formerly global co-head of client management in New York, has moved over to run the business, which will provide capital raising solutions in the debt and derivatives markets, reporting to Cacorino and Mauer.
The other new coverage areas are two global macro sales divisions. Anu Jayanti and Zoeb Sachee, who report to Cacorino and Mauer, will co-manage the new non-Japan division, which combines elements of Citi's macro hedge fund coverage from the current futures, rates and foreign exchange sales groups.
Jayanti and Sachee hold on to the current management responsibilities for global foreign exchange investor sales and UK rates and futures, respectively.
In addition, Jayanti is to run all institutional investor foreign exchange sales including those to real money, global leveraged fund and bank investors. She reports jointly to Jeff Feig, and Cacorino and Mauer in that position.
For Japan, Junji Hisatsugu will run the new macro sales group, which combines the existing foreign bond sales team with the international yen sales team.
Away from the new coverage areas, Citi has reshuffled chief salespeople in its global client management, global emerging markets and Latin American sales divisions, as well as in its north American securitised markets, US rates and Asia-Pacific businesses.
The GCM business will be run globally by Ed Leventhal, formerly head of global emerging markets sales.
In Europe, John Colligan will continue to run the business in the region, reporting to Leventhal, who will also assume direct reporting responsibility for the north American branch sales offices.
Fintag says Citi may have a big balance sheet and a strong retail presense but its forays into alternatives have been a joke. And they still are.
They should stick to fixing their ATM's because they never work with my black AMEX.
PAPER SCISSORS STONE
In Subprime Fall-Out, Hedge Funds Call on ISDA (hedgweek) Hedge funds are disputing bank decisions on subprime mortgage loans, and several funds have asked the International Swaps and Derivatives Association to work toward an industry-wide solution to the difficulties that these decisions have created for the credit default swap market.
The Financial Times reported Thursday [May 31] that 25 hedge funds have sent a letter of complaint to the ISDA. HedgeWorld can't confirm that number, but the letter is real.
Robert Pickel, the ISDA's chief executive, reacted to the letter Friday morning. "ISDA's documentation and its extensive work in respect of privileged information relating to the credit derivatives business make expressly clear that parties must not only comply with the law but must also observe sound practices and principles in the conduct of such business," he said.
Hedge funds, which are often the buyers of protection in a default swap, claim that banks are making concessions on underlying non-performing mortgages to avoid acknowledging a default event under the terms of the CDS.
"We are aware of a proposed documentation change recently submitted to ISDA by a derivatives dealer that, though subsequently withdrawn, clearly demonstrates the intent to provide cover for manipulative conduct," the authors wrote in the letter to the ISDA.
The issue is a crucial one for the distressed-debt segment of the hedge fund industry, which is eager to find opportunities as homeowner defaults pick up and real estate prices fall Previous HedgeWorld Story. That, though, will require an environment of legal and contractual certainty.
"These are institutions that affect many different financial institutions and the integrity of a major market, not merely issues between individual counterparties," according to the hedge funds' letter. "Therefore, ISDA should actively promote an industry solution that assures market participants that no one can engage in practices that are manipulative and prohibited by existing securities laws."
The hedge funds added that they'd like to be included in any meetings regarding this issue. The ISDA has thus far made no specific reference to that, although its membership is said to be discussing that and related points now.
In mid-May, Mr. Pickel signed an open "ISDA Year in Review" letter. The letter mentioned briefly that the ISDA anticipates developing a standard terms supplement approach for commercial mortgage-backed securities, residential mortgage-backed securities, collateralized debt obligations and other asset categories so that confirmations can be more streamlined in their execution through Depository Trust & Clearing Corp. and other services. But it isn't a mere streamlining of execution that the hedge funds desire.
Fintag says You know when things are going down the tubes when
1. You spend more time with your lawyers than usual 2. You take longer than usual to sign off your month end 3. You start reading your ISDAs
We may have to overcome our objections. House price inflation is cooling in England and Wales - but still rising in Scotland and Northern Ireland, although for how long? - and the assumption that property prices can only ever move in one direction may need to be revised.
In April mortgage levels fell to their lowest for a year. It could mark the start of a prolonged cooling-off. Nationwide, Britain's largest building society, says that house price growth across the country is set to slow further in 2008 to just under 5 per cent. Fionnuala Earley, its chief economist, pointed out that the three-month rate of house price inflation was running at 3.5 per cent in January. By May, that rate had more than halved.
The average price of a home is now about 10.3 per cent more than a year ago, but the underlying picture leads economists to predict that annual inflation will have fallen to between 5 per cent and 8 per cent by December. Price inflation in the North of England has already slowed to 5.3 per cent during the first half of this year.
End of house price boom is in sight
Societies saw an 8% drop in mortgage approvals last month compared with a year ago, the first such fall since 2005
The question that always accompanies fresh data showing a fast-growing housing market is: are we headed for a crash?
True, in London and a handful of its satellite cities and towns prices are still roaring ahead. Estate agents believe that they will carry on rising in 2008 at a multiple of the increase in average earnings, possibly by as much as 10 per cent. Cash-rich buyers in the South are less influenced than their northern brethren by the recent rises in interest rates. These buyers are chasing a limited stock of housing, forcing up prices. Savills, the property agent, records inflation of up to 40 per cent for sales of multi-million-pound homes in parts of Chelsea and Belgravia in just the first five months of this year.
Yet beyond the enclaves of West London, the picture is less rosy. But will the predicted cooling become a crash? A few key assumptions will come into play.
The first is confidence. The housing market relies on confidence like any other. First-time buyers in Bolton need to be confident that their astronomical mortgage is worth it, just as Belgravia depends on confidence that London will continue to be a magnet for international money. If interest rates rise much above 6 per cent, experts believe that much of this confidence could evaporate.
During the last housing crash, of 1989-94, interest rates spiralled to more than 15 per cent. Yet the price of an average home in Britain today is three times the cost of one 15 years ago. That means that it takes a much smaller rise in interest rates for home-owners to find themselves in difficulties maintaining the bigger borrowings needed today.
Yolande Barnes, head of residential research at Savills, said: “We are in uncharted territory. A lot of the market is based on the willingness to sink large amounts of wealth into housing. It is confidence-based. That tends to make it more volatile. There is even a problem if interest rates get to 6.5 per cent. That is the absolute biting point. That would probably trigger a household debt crisis similar to the late 1980s.
“We think at that point all the household spending surplus disappears, once you have paid housing costs and the basic cost of living. A widespread crash is, however, unlikely. It would take extreme circumstances and the broad economic environment is benign.”
There is a third assumption, which cannot be tested by looking back to the last housing crash. Buy-to-let investors are relatively new in the market. Figures from the Council of Mortgage Lenders show that buy-to-let mortgages totalled £38.4 billion last year, representing 11 per cent of mortgage advances made during the year. Two years ago some analysts predicted a wave of forced sellers among buy-to-let investors that they said could send house prices crashing 40 per cent. That fear never became reality.
Property pundits will hope that these new real estate owners remain long-term investors as interest rates start to rise.
Fintag says As usual the UK lags behind everything the US does (except in popular culture, fashion and car design) but the end of the 1980s type obsession about property is coming to an end and with that confidence will fall and market volatility will return and I will be happy, happy, happy.
SPIES
G8 summit to call for hedge fund vigilance (reuters) Leaders of the G8 powers will call this week for greater vigilance on hedge funds in the hope that the industry will take it upon itself to prevent accidents like the collapse of LTCM in the late 1990s.
The call, to be made at a summit hosted by German Chancellor Angela Merkel, falls way short of Berlin's attempt to crack down on an industry which has blossomed in recent years in the shade of mainstream funds and banks, which are more closely regulated.
"It's the first time the call has been made by a G8 summit, so it's significant in itself," said one official involved in negotiations for the gathering in Heiligendamm on Germany's Baltic coast, taking place from Wednesday to Friday.
A statement to be published at the summit says G8 leaders -- from the United States, Japan, Germany, Britain, France, Italy, Canada and Russia -- prescribes "greater vigilance" and better efforts to improve the transparency of hedge funds.
Once solely reserved for millionaire investors, hedge funds are now a major source of profit for more traditional financial institutions such as banks, raising two key questions about the risks of funds that use high-risk investment strategies:
Would a hedge fund crisis pose a systemic risk for the rest of the financial system? Should investor protection be improved as hedge funds forge closer links with banks and pension funds which invest for people well below the millionaire bracket?
Berlin tried on several occasions in recent months to win G8 support for tighter regulation of hedge funds or, short of that, a code of conduct.
Finance Minister Peer Steinbrueck said after a meeting of G8 finance ministers in Germany last month that he still believed a code of conduct would one day apply, if not in the near future.
He has received little backing since then from France or Italy and failed to overcome outright opposition from Britain and the United States, fans of a more hands-off approach.
"It's gone nowhere," a second official said. Both officials who spoke to Reuters did so on condition of anonymity because of the sensitivity over the statement set to be published in the G8's name in Heiligendamm.
BAD IMAGE
One bad memory that haunts governments and regulators is the demise of Long-Term Capital Management, which was a huge profit-spinner until it got burned in the financial crisis when Russia defaulted on its debt in 1998.
The U.S. Federal Reserve had to orchestrate a multi-billion dollar bailout for fear that the fund's implosion would trigger a chain reaction in the financial system more generally.
Since then, the hedge fund industry has bounced back, aided by five years or so of strong economic growth and low interest rates that spurred the quest for bigger returns.
Business has expanded five-fold with assets of $1.6 trillion under its management, according to a report commissioned by G8 governments from the Zurich-based Financial Stability Forum.
Washington and London argue that less ritualistic but more real-time and continuous contact between supervisors and hedge funds will be more effective in detecting potential trouble.
Fintag says At this time of year I try to keep a low profile.
London hedge fund scours Japan for more deals (reuters) The Children's Investment Fund (TCI) is scouring Japan for more deals but sees its struggle to raise the dividend at Japanese electric power wholesaler J-Power as a test case for further investment, a TCI executive said on Monday.
TCI also said it is proposing that J-Power maintain a higher level of dividend payouts, not just a one-off hike, as a sign of sustained shareholder friendliness.
"We would like to invest more here," said John Ho, TCI's head of Asia-Pacific investments during an interview with Reuters. "The issue is whether that value is able to be unlocked, partly because of capital management issues."
TCI, a hedge fund with headquarters in London, suggested in March that J-Power -- Japan's Electrical Power Development Co. -- raise its relatively low full-year dividend to 130 yen.
J-Power retorted that the proposal from its largest shareholder would reduce resources earmarked for growth, drawing the battle lines for the company's shareholder meeting on June 27, where 50 percent of the votes will decide the issue.
Investor activism is increasing in Japan, forcing a debate over the appropriate level of returns to shareholders. Tension between management and their more vocal investors is expected to climax at the flurry of annual general meetings slated for this month.
Funds are highlighting corporate Japan's low dividend payout and return on equity compared to the United States and Europe, and are hustling for change. If TCI carries the day, the fund and its peers may look more favourably on investing in Japan.
"We want to see how Japan will react," said Ho, adding that the outcome at the shareholders' meeting will affect future investments.
TCI has billions of dollars invested across Japan, Hong Kong, South Korea, India and South East Asia.
"We live in a world which competes for capital... If we find Japan to be unattractive then we will go elsewhere," Ho said.
Ho said he had recently visited Japanese companies in the machine tool, consumer and real estate sectors with a view to investing.
TCI, named after its donations to children's charities, manages over $10 billion of assets globally. Returns to its investors from around the world are over 30 percent, said Ho.
Its 9.9 percent stake in J-Power is its biggest investment in Japan. TCI holds 9.9 percent stake, worth about $800 million.
Chris Cooper-Hohn, TCI's founder, became the face of European hedge fund activism in 2005 when the fund criticised Deutsche Boerse's approach to the London Stock Exchange, eventually forcing the German bourse's chief executive to resign and torpedoing the bid.
TCI was also instrumental in prompting a bidding war for Dutch bank ABN AMRO, which could result in the biggest banking merger of all time.
TCI has bought stakes in other power companies around Asia, including Japan's Chubu Electric Power Co., Hong Kong's Link Reit and China's Huadian Power International Co. Ltd.
Fintag says Barrel. Scraping.
LOCUSTS ON HOLD
Germany sees no quick fix to hedge fund oversight (reuters) German Finance Minister Peer Steinbrueck reiterated his wish to see greater oversight of the hedge fund industry ahead of a key summit, but said he did not expect consensus on the matter to be reached quickly.
As leaders of the Group of Eight (G8) industrialised nations prepare to meet in Germany's Baltic resort of Heiligendamm on June 6-8, Steinbrueck said the government was hoping to broker an agreement that would lower the risks posed by the funds.
"The government is trying to reach international consensus on potential measures that aim to limit potential systemic risks for financial stability," he wrote in a guest contribution for the weekend edition of the Boersen-Zeitung business daily.
"Our aim is an international code of conduct, which the (hedge fund) industry -- also in its own interests -- applies to itself. It's also clear that we're only at the beginning of the debate and that there will not be any quick decisions."
He added that enforcing binding legal regulations on hedge funds was not feasible, but that this would not be necessary either if the funds submitted to indirect oversight.
"To supplement the indirect approach I'd like to see market discipline strengthened by making hedge funds more transparent," said Steinbrueck, who said in May he did not expect a deal to emerge on hedge funds at the Heiligendamm summit.
However, the minister also told Reuters last month he hoped the outlines of a code of conduct could be agreed by the time Germany's presidency of the G8 concludes at the end of 2007.
German efforts to forge consensus on hedge fund oversight have had to contend with a cautious attitude to regulation from countries such as the United States and Britain.
Fintag says And why should we listen to anything the Germans say? How many German Hedge Funds can you think off? That would be none.
YESTERDAYS NEWS
More equity hedge funds turn to shorting ETFs (marketwatch) Some equity hedge funds have quit short selling stocks because the strategy is riskier in a rising market and has become too crowded to be profitable. Instead, more managers are shorting exchange-traded funds.
That's a problem, according to some experts, who argue that using ETFs to hedge equity portfolios is a poor substitute for the real thing. Others say the trend shows managers are adapting to a trying environment for short sellers.
Short selling involves borrowing a stock and then selling it. If the shares fall, the trader can buy them back at a lower price and return them to the lender at the original price. The difference is kept as profit. The managers of equity hedges sell stocks short to protect their portfolios from stock-market declines and to help them generate "alpha" -- industry parlance for extra returns, above what's available from the market.
When stock markets rise, as they have been doing recently, short selling becomes more difficult. Short sellers tracked by Hedge Fund Research lost 7.42% through April this year. The Standard & Poor's 500 index was up roughly 5% during the first four months of 2007. But some investors and managers say a rising stock market isn't the sole issue. The rapid growth of the hedge-fund industry and the leveraged-buyout boom are also making the practice of shorting stocks less attractive.
"The single-stock-shorting game has become absolutely treacherous," said Jeff Bernstein, co-founder and managing director of hedge fund Keel Capital Management LLC. "Because of the growth of hedge funds, there just aren't that many companies available to short now -- competition for shares to borrow has gotten intense." See related story on the difficulties of short selling.
Bernstein and colleagues shut down Keel at the end of February partly because of a lack of attractive short-sale opportunities. Without good short ideas, Keel often had to trim its long positions to keep the fund within its strict strategy parameters. See full story.
Keel also refrained from using ETFs to hedge its portfolio because that strategy can inflate losses when stock markets fall, Bernstein said. It can also be a duller tool, leaving managers betting against "good" companies that happen to be in an index alongside more troubled rivals, he added.
Still, facing investment headwinds, an increasing number of equity hedge funds are shorting ETFs instead of single stocks. ETFs are indexed baskets of securities that, like shares, trade on exchanges throughout the day. They can be sold short or bought on margin, and many have listed options. Given Keel's problems, Bernstein said that if he were starting a hedge fund today, he would "absolutely" give the vehicle more leeway and allow it to short ETFs.
ETF short interest has jumped 44% to $85 billion since the end of 2006, Paul Mazzilli of Morgan Stanley MTH ) , has attracted short interest of 192%, Mazzilli reported.
ETFs are easier to short because they're not subject to the "uptick" rule, Mazzilli said. (The uptick rule on the New York Stock Exchange and Nasdaq means that shares cannot be shorted unless their prices first rise.)
ETFs are traded more than some stocks, which also makes them easier to short, Mazzilli added.
Increased shorting of ETFs by equity hedge funds shows that managers are adapting to a strong stock market that's fueled by leveraged buyouts, or LBOs, according to Cynthia Nicoll, chief executive of Tremont Capital Management, a fund-of-hedge-funds firm. When a heavily shorted company is acquired, short sellers have to cover their positions by buying back stock and returning it to a borrower. That process can push shares even higher in what's known as a short squeeze.
'We're concerned to see managers abandoning the whole concept of shorting single stocks. There is some of that happening out there.' — Oscar Leal, 1794 Commodore Funds
By shorting a basket of shares, rather than one stock, there's less chance of being hit by a big short squeeze when a buyout is announced.
"Hedge-fund investors hire managers to make money in all types of markets, and this strategy works in this type of market," Nicoll explained. Once LBOs become less prevalent and the stock-market cycle turns, equity hedge funds will start shorting individual shares again, she predicted.
ETFs can also be used in combination with other positions to isolate a stock that's difficult to borrow, according to Joe Weinhoffer, chief executive of Quadriserv Inc., a New York-based firm that specializes in helping hedge funds and other traders borrow securities.
One hedge fund with which Weinhoffer is familiar was struggling to borrow a stock and instead shorted an ETF that contained the shares, he said. The manager then took long positions in all the other stocks in the ETF.
"That gave them short exposure to that single stock through the ETF trade," Weinhoffer explained. "That's expensive, but they believed the stock was going to go down."
Problems But there are also problems with managers using ETFs to hedge their equity portfolios, Weinhoffer said. ETFs have more moving parts than a single stock, he explained. If a hedge-fund manager wants to short a couple of hard-to-borrow biotech stocks, for example, the manager could more easily bet against an ETF covering that industry.
But when managers do that, they're not just shorting the two stocks they want to target; they're also betting against several other companies that they may not know as much about, Weinhoffer said. "There's extra risk there."
Bernstein noted that equity hedge funds typically go long stocks with high betas (if the market goes up or down 1%, these stocks will go up or down 1.5% or 2%, for example). If funds are also short an ETF, these usually have a much lower beta (they move more in step with the market). So, if the market goes down 1%, the ETF position may rise by 1%, but the long positions could go down by 1.5% or 2%, he explained.
Increased shorting of ETFs also poses a dilemma for funds of hedge funds, which allocate money to a range of different outside managers, Bernstein said.
These investors like to invest with managers who focus on different strategies and hold different securities. That diversification cuts the risk of big losses. But if a lot of managers are shorting ETFs, returns and losses may be more correlated than investors realize, Bernstein explained.
ETFs are also indexes, and so, by definition, they provide so-called beta -- that is, the return generated by the market. Hedge-fund managers are in the business of creating alpha and outpacing the market benchmarks. So if they build short positions with ETFs, that part of their strategy will track whatever portion of the market they're betting against. That could end up looking more like beta than alpha. Investors may be better off investing with a mutual-fund manager who is a great stock picker, then shorting ETFs themselves, Glen Dailey, head of prime brokerage at Jefferies Group, said, adding that this strategy would incur fewer fees.
"Why would people be willing to pay a 20% incentive fee for a hedge-fund manager who's just shorting ETFs?" he said. "It's great as a tool but not a good hedge-fund strategy." Bernstein said this idea makes sense, but he added that in practice it would be much harder to do successfully. "A hedge-fund manager will say, 'I'm rotating and changing short exposure all the time to create excess returns,' and some people are very good at that," he said.
Other investors say they want hedge funds to continue shorting single stocks rather than ETFs and point out that there are still lots of potentially profitable short ideas available.
"We like to see individual short disciplines, but we're somewhat flexible, and we understand the difficulties right now," said Oscar Leal, a portfolio manager at the 1794 Commodore Funds, which invests in hedge funds. "We're more concerned to see managers abandoning the whole concept of shorting single stocks. There is some of that happening out there."
Despite strong equity markets this year, some dedicated short sellers are still making money. Kingsford Capital, a short-selling investment firm that specializes in deep research of small companies, was up roughly 1.5% through the end of April, according to two hedge fund investors who declined to be identified.
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