Market malaise is not caused by hedge funds

UBS warburg reportS such a small asset class is not to blame

Commentators have oversimplified the cause of recent market volatility, laying blame squarely at the feet of hedge funds which control only 2% to 3% of global managed assets, according to analysts at UBS Warburg.

A recent note from the brokers on short selling reported that, although hedge funds account for roughly $600bn, outright short sellers make up just 0.11% of assets under management, compared with 0.12% of assets in 1990.

'Such a small asset pool can hardly have brought about the current situation,' said Alexander Ineichen, head of equity derivatives research.

'Two of the largest styles (among hedge funds), equity hedge and equity non-hedge, make up 42.5% of the asset pool, and they ought to be net long equity if they are adhering to their mandates. We believe that, as they suffered losses in June, this would have been the case,' he added.

'We believe blaming hedge funds is less a case of intelligent comment and more a case of sour grapes.'

UBS Warburg said a number of factors have driven traditional buyers from equity markets and this desertion has impacted prices and volatility, for which hedge fund short selling has been recently blamed.

The dot.com bubble, Ineichen noted, left many investors, both buyers of tech shares, as well as telecoms and media firms linking up with or buying dot.coms, with poor quality investments and a realisation information they had assumed correct about the firms was in fact false. Credibility of the analysis of some shares was thereby eroded.

'The consequence is that large numbers of buyers are no longer willing to pay for the higher quality shares, because they cannot distinguish them from the lemons,' Ineichen said.

Data from US fund flow monitor Trimtabs suggests US retail investors have withdrawn $70bn from equities between 1 June and mid-July, this is nearly 50% of the $170.6bn the Investment Companies Institute-reported. In addition, the brokers noted, markets have plummeted as life insurance and annuity product providers saw their liabilities grow as interest rates fell and solvency levels were tested.

'If equity values are falling and volatility is increasing while bond values are rising, non-life insurance firms have a natural incentive to reduce their exposure to equities and increase exposure to bonds instead. Pension funds share this asset/liability balancing problem,' Ineichen noted.

'If such a large portion of the professional asset management industry has strong incentives to sell equity, we believe it is neither fair nor reasonable to single out a small portion of the industry ' hedge funds ' as the cause of the current stock market malaise.'

Although short selling may not be responsible for a large part of recent market volatility, short sellers still hit a high in returns from shorting during the second quarter of 2002.

Data from Hedge Fund Research and Datastream shows that short sellers produced an aggregate return in 2002 of 22.7%, almost triple the strategy's return in 2001, and hit a 12-year peak at the end of June.

'Looking at how world equity markets have performed since, we think it likely the index will turn in another positive result for July,' Ineichen noted, as the outlook for shares remains grim.

Even if everything goes well, the MSCI World index will only reach its all-time high of 1,449 points from 27 March 2000 by October 2009. The S&P 500 could reach its former peak of 24 March 2001 (1,527.5 points) by May 2006, he added.