The Below The Radar Hedge Fund Crisis

The other day, with the market giving up about a third of its March gain in DJIA points, I went looking through my favorite market stats to see if any remaining profits could be pounced upon. Typically, profit possibilities can be identified quickly on NYSE lists of the largest dollar and percent gainers.

Alarmingly, 75% of the largest percent gainers were ETFs, and many of those operate using the same strategies as classic hedge funds--- most owned no common stock at all! At the same time, 93% of the largest dollar gainers were ETFs with a large proportion plainly operating like a hedge fund.

Earlier in March, while we were all sunning ourselves in the far-too-infrequent-lately UVs of a brief rally, I was doing a similar search for undervalued IGVSI stocks. Yes, Virginia, there is an equally impressive array of hedge funds betting that the markets (and the South) actually will rise again.

What is a hedge fund, and just what does it try to accomplish? I think the key legal element is that they don't say how they intend to get the job done.

Initially, hedging was used as a risk mollifier in the securities markets in the same way as insurance is used for protection against disasters impacting life, health, and personal property. Taking a short position on an owned security, for example, protects an investor's profit if the company's market price plunges.

Naked shorting, shorting baskets of securities, and shorting indices, however, have morphed into a risk creator, not a risk reducer. Similarly, hedge funds that hold index funds as betting devices on market sector performance are not what the investment gods envisioned when they blessed the sector experiment.

The new definition of hedge fund speaks of an aggressively managed entity that uses leverage, long, short, options, futures, and derivative positions with the goal of generating high returns. Risk reduction is no longer the objective.

Hedge funds have never been regulated like their open-end mutual fund cousins--- the rationale being that they cater to a wealthy and sophisticated clientele. In fact, the law requires that participants in hedge funds jump over income, net worth, and investment high-hurdles before being eligible to participate.

Investopedia refers to them as mutual funds for the super rich, but the only similarities to the plain vanilla equity mutual fund are the pooling of participants' money and professional management. During the past decade, a series of ill advised and shortsighted rules changes gave hedge fund managers destructive powers that exacerbated the financial crisis that will mourn its second anniversary this summer.

But regulating the hedge fund is clearly a too late closing of a barn door encrusted with diamonds (no pun intended). A few years ago, the masters of the universe rediscovered, redefined, and complicated the world of closed end mutual funds by creating many different forms of passively managed index/hedge funds.

As innocent as these funds may appear, they too have altered the investment landscape. Speculators (not investors) place their bets on the rise or fall of the index. These bets artificially impact the market price of securities because many (if not all) of the funds actually own the securities they are tracking.

Additionally, many individual stocks fall into several indices, and most of the major ETF marketing companies sell similar index funds. Didn't we just go through this with mortgage-backed securities? Aren't these funds artificially taking common stock pricing further and further away from the fundamentals of the companies themselves?

Today, it appears that every passive fund has two or three accompanying short/bear ETFs plus an equal number of bull/long funds to choose from.

Apparently, the SEC has not taken the trouble to look inside the thousands of boutique ETFs that by now must outnumber the securities they are tracking.

Wall Street wants all CEFs (index, hedge, bond, equity, real estate, whatever) to be regulated and reported upon as though they were simply common stocks. As a whole, they aren't even close. In fact, there are more of these derivatives traded on the NYSE than common stocks and preferred stocks combined.

And the real crime is this: investors as naive as the wet-diapered E-Trade spokesbaby can push a button and buy operational hedge funds more bizarre and sophisticated than any ever imagined buy the rich and famous.

If an ETF harbors a hedge fund, but doesn't call it a hedge fund, is it really not a hedge fund? If Merrill Lynch creates a mutual fund with pro rata individual account statements, is it any less of a mutual fund? Is it really individual account management? Have the commissions really disappeared? The SEC thought so.

Shouldn't the regulators be smart enough (and brave enough) to put an end to these legal-in-name-only frauds? Should your mother's IRA be speculating in puts on Netherlands Tulip Bulb futures? How about 200% of the inverse of the Financial Select Sector Index?

A search at ETF-Connect for US Equity ETFs finds roughly 500 potential speculations that absolutely anyone can buy into. All are self-directed IRA eligible--- 401(k) eligible, possibly. A look inside reveals hedge-fund-like operations. But technically, they are not hedge funds because they describe the strategies employed.

So long as we tolerate Wall Street attorneys circumventing the intent of our securities laws, and so long as we reward regulators for their blind worship of the letter of these laws, we will have this kind of manipulation.

Index ETFs (and the no doubt about it hedge fund casinos they front) need a league of their own, located in Vegas, AC, or Uncasville. (A free "Brainwashing" book to the first three people who explain Uncasville!) They demand a new rulebook that recognizes content and strategy--- not trading form.

The ETF derivative market requires a fresh new breed of big picture aware, loophole fillers --- the Obama team is accepting applications.

Whatever happened to stocks and bonds?

Steve Selengut

http://www.sancoservices.com/

http://www.kiawahgolfinvestmentseminars.com

Professional Investment Management from 1979

Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"