Saturday, July 17, 2004

Market Bubble Watch: Fear Factor Speculation

Here from your friendly neighborhood oldman comes links to two stories that emphasize how truly expansive this asset inflation bubble is becoming. The first is a story on venture capitalism gone reckless again via the NYT.

The question is what will happen to all those millions that do not get into top-tier funds like Kleiner Perkins or Sevin Rosen - money that plenty of other venture capitalists would be happy to accept but would not necessarily be able to invest effectively, given a limited pool of bankable ideas. And if too much venture money chases too few deals, the industry may have another mess on its hands.

Yet an oversupply of money hurts the performance of the top firms as well as those at the bottom - as has been demonstrated so far by the funds raised in 1999 and 2000. Because five or more years can pass before a venture-backed start-up goes public or is acquired, it is too early to close the books on funds from those years. But even Sequoia and Kleiner Perkins, which would make almost anybody's list of the top five Silicon Valley venture firms, are sitting on money-losers raised during that time, according to performance figures from the University of Michigan...

IF there are 5 winners in a market sector and 10 losers, the winners still make up for the losers," said Steven Dow, a Sevin Rosen partner. "But what we saw happening during the boom is that 30, 40, 50 companies would be funded in the same market. Five winners don't make up for 20 or 30 or 40 losers."...

If investors appear not to be demonstrating the same discipline as the top venture capitalists, one reason may be the so-called funds of funds - essentially mutual funds for the very wealthy. The professional money managers who run these funds are paid a fee based on the money they manage, but, of course, they cannot collect that fee if they cannot invest the money.

"If you run a fund of funds and you can't move the cash into venture, then you're out of business," Mr. Dow said.

Others fret over all those pension fund managers who did not discover venture capital until the late 1990's. Typically, those running a fund of funds invest their own money alongside their clients', and are thus motivated to choose only those funds that pass muster. Pension fund managers, by contrast, are investing other people's money, typically according to a formula set by a board.

"The real moment of truth for our industry comes in mid-2005, when most of the top 30 or 35 firms will have raised their funds," Mr. Jaggers of Sevin Rosen said. "At that point, if you've got a big old fund of funds, and you've got another $300 million to invest, you've got a big problem. I'm very concerned."

If that was the only sign of a bubble, perhaps we could dismiss it as a sign of Silicon Valley exuberance. However the hedge fund industry has been exploding the last several years, and is showing every sign of using increased leverage (therefore requiring ever greater and greater credit lines) in order to extract ever narrower returns from arbitrage. (The Economist)
Depending on whose figures you believe, there are 6,000-8,000 hedge funds around the world, which together manage $1 trillion or so. In the first quarter of this year, some $38 billion flowed into hedge funds, according to Tremont TASS, a research firm—over half of the total for the whole of last year. Small wonder that hedge funds, hitherto lightly regulated, should be attracting the attentions of financial-industry watchdogs (see article). Yet hedge funds still control less than 2% of all investible assets.

It used to be that most of this money came directly from rich people. Now much of it comes via private banks, which these days advise clients to invest in hedge funds as a matter of course. Increasingly, however, a lot of the money comes from pension funds and insurance companies, which once viewed hedge funds with the utmost suspicion, but after the dismal stockmarket of 2000-02, cannot now invest quickly enough. Mickey St Aldwyn of International Fund Marketing, a hedge-fund marketing company, reckons that such is the weight and momentum of institutional money flowing into the market, hedge funds will be managing a colossal $3 trillion within three years.

But therein lies a problem. Traders flock to set up hedge funds because they can earn a lot: typically, funds charge a 1% management fee and 20% of profits. Good, or at least popular, managers can charge what they like. Renaissance Technologies charges a 5% management fee and takes 35% of the profits. SAC takes no fee but half the profits. But whether investors should fork out such sums is debatable: the large amounts pouring into hedge funds are driving down the returns that attracted that money in the first place...

Nor are hedge funds the only ones pursuing these strategies. If hedge funds look like banks' trading operations, that is because they are indeed all but identical: many hedge funds started life when a bank's traders decided that they could make more working for themselves than punting the bank's capital. And lately, banks have decided that trading is such a wonderful business that they have devoted even more capital to it.

For many trading strategies, however, there is a limit to the amount of money that can be moved around cheaply and briskly. While punting large amounts on the highly liquid foreign-exchange or government-bond markets is easy, betting on illiquid corporate bonds or shares is far harder. And the larger the amounts, the more expensive the bets are.

It is for this reason that many of the oldest and best-known hedge funds will not accept any new money. Some have even been handing capital back to investors. Vega itself had told some in the industry that it did not want to grow above $2 billion, though it now clearly has more confidence in its abilities.

Whether this is justified remains to be seen. Performance in general seems to be deteriorating. In the late 1990s, says Mr St Aldwyn, no one would touch a fund that did not claim to be able to make 15% a year. Now investors seem happy with a promise of high single-digit returns.

Even this seems beyond many. In the first six months of this year, most funds were flat or slightly positive: the CSFB/Tremont investible hedge-fund index is up a touch over 1% so far this year. April and May were two of the worst months for years. Many in the industry find that disturbing, given that almost nothing nasty happened in the markets. “It's all doomed in one way or another,” says one hedge-fund manager. From alpha to omega in a few short years?

Reading the market signs and between the lines of the commentary of the venture capital firms and the hedge fund managers as reported in The Economist that the market is poised for over saturation in mid to late 2005. This next twelve months would then be since it is also a year of real estate bubble assets the "year of the market bubble". Despite my previous commentary about a bubble, the early signs indicate that it is not too late to prevent a bubble deflation and sharp correction of price values - given a change in Federal Reserve Policy. The fact that you can't fight the Fed goes both ways. Previously investors and speculators could only live in the reality created by historically low interest rates. However the converse is now true. No individual market mover can change the course of affairs that the Federal Reserve has set. Given the softening in economic numbers despite the press and rhetoric otherwise by economists out there, Greenspan is unlikely to accellerate or stiffen his monetary policy recommendations and neither is the Open Market Committee likely to override their captain. So the rest of us are forced to lounge around on the deck of the Titanic, seeing the glint of the ice on the horizon but unable to convince the captain to change course. The main emphasis should then be on protecting mainstream portfolios and their principal rather than chasing returns in a market with the oxygen sucked out of it. Just make sure whatever you're investing in doesn't dabble in hedge funds or derivatives. While there are some good ones, the average investor won't be able to smell out the rats until they see them swimming away from the sinking ship.

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