Financial markets were severely jolted last year as the sovereign credit ratings of Japan, the US and many European nations slipped.
However, at the close of trading on the last day of the year, the Standard & Poor’s 500 index by chance stood at 1,257 points — exactly the same as at the end of 2010. With the stock market back to where it had started a year earlier, many fund managers found that they had worked hard all year for nothing.
The worst performers of all were hedge funds, whose purpose is to secure absolute returns. Sixty percent of hedge funds ended in the red, making last year the second-worst year for hedge funds in 20 years. Only in 2008 did they fare worse.
Bloomberg’s main hedge fund index showed a drop of 9 percent for the year. Although the loss was less than 10 percent, the performance of the hedge fund index was 15 percent worse than that of the Dow Jones Industrial Average, which gained 5.5 percent over the year.
Not only did hedge funds fail to deliver absolute returns, they also performed worse than index-tracking funds. That made last year a really bad year for the world’s big financial “crocodiles.”
Superstar fund managers have been losing their auras. John Paulson, who did well in the 2007-2008 financial crisis, has taken a big tumble, with his Advantage Fund last year dropping 36 percent and his Advantage Plus fund plunging 52 percent.
After becoming a billionaire by short-selling subprime mortgages in 2007, Paulson made a high-profile entry into the gold market. However, while the price of gold, in US dollar terms, rose by a little more than 10 percent last year, his gold fund fell by more than 10 percent.
Investor George Soros, who amassed massive wealth by speculating against the British pound and laid waste to the currencies of Southeast Asian countries, is also facing losses. In the middle of last year he wrote a letter to his shareholders announcing the end of his 40 years in the business of hedge fund management. He returned funds to external investors and told them that he would no longer be managing assets on their behalf.
His explanation was that he did this in response to recently announced financial regulations, and to avoid having to register with the US Securities and Exchange Commission and accept regular financial auditing, in line with the new rules. However, it is also an open secret that his company’s funds have not been performing very well in the past few years.
Interest rates around the world remain low, so the cost of raising capital is close to zero. Against such a backdrop, hedge funds have been performing worse than the stock market as a whole.
Is this the quiet before the storm, or is it because hedge funds have pulled out of arbitrage trading?
In the past, financial derivatives, including credit default swaps, made lots of money for hedge funds. However, the profits from these complex transactions have fallen in the wake of deleveraging and a decrease in proprietary trading.
Hedge funds are no longer able to provide better returns than the stock market as a whole and are no longer producing absolute returns. As a result, investment could return to its most basic form, with more funds flowing back into conventional stock market investment.
Investors can be expected to shift their attention back to the potential of companies that focus on technology, pharmaceuticals and the development of new energy sources.
If investors move away from short-term trading and back to long-term investment, it will be have the benefit of increasing the stock market’s overall price-to-earnings ratio and will also spur greater innovation in technology, medicine and new energies, which would be good for the national economies and for people’s daily lives.
Of course, there is another possibility that should not be overlooked. The reason why most hedge funds haven’t been making a profit could be because the scenarios they are betting on have not yet played out.
The hedge funds that profited from the 1997 Asian financial crisis had already been deployed for action a long time before they chose to strike.
In 1997, international speculators started attacking the Thai baht, and in the following six months the currencies of countries such as the Philippines, Malaysia, Indonesia and South Korea lost anywhere from 20 to 60 percent of their value and their stock markets turned into killing fields.
Within half a year, the stock markets of the four “Asian Tiger” economies — Taiwan, South Korea, Hong Kong and Singapore — were in shambles, as were those of the “tiger cubs” — Thailand, Malaysia, Indonesia and the Philippines.
With many economies in a serious recession, unemployment rates kept rising and the streets were full of people looking for jobs. The fruits of economic growth had not trickled down to medium and lower-income earners, and the financial crisis made the lives of those who were already struggling even harder.
A string of protests erupted in Southeast Asian nations, the worst of them being the Indonesian anti-Chinese riots of May 1997.
The strength of many hedge funds lies precisely in this ability to prey on weakness. They watch carefully, wait patiently, search for opportunities, deploy strategies and wait to reap the rewards. Hedge funds buy up shares on the quiet and then, when the time is right, they make big moves to encourage investors to follow them into the market and join in their attacks.
Today the stage for crises has shifted to other regions. Now it is developed nations that are finding themselves tangled in a web of debt. These countries’ sliding credit ratings are a prelude to future instability in financial markets.
The financial tsunami of four years ago might not be repeated, but the looming shadow of a new kind of crisis is as depressing as Taipei’s incessant winter rains. Last year was a slow year for hedge funds.
Will this year see investment get back to basics, or will it be yet another year of blood and bruises? Only time will tell.
Jason Yeh is an associate professor of finance at the Chinese University of Hong Kong and a visiting associate professor in the College of Social Sciences at National Chengchi University.
Translated by Drew Cameron
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