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Gold could benefit when the hedgers defaultFUNDS, those American money managers who attract the savings and pensions of the people and aim to make impressive returns, have the power to move markets, destroy economies and bring down governments. A combination of self-regulation and greater transparency is needed to check them. The former is likely but the latter only a wish. These are the findings of Virtual Gold's Jessica Cross, who analyses 1 729 hedge funds quarterly. She explains how the funds work. Large ones take the money entrusted to them and borrow against it. These leveraged amounts are then invested in currency, commodity or financial instruments. When everyone else knows about it, other funds, whose actions are usually triggered by computer, follow suit. The more money drawn into the strategy, the greater the potential profit for the hedge funds as their outlook is proved right. A self-fulfilling process is then in motion. But as the large funds begin to unwind positions and take profit, the smaller funds also respond and the potential profit margin narrows.
Cross notes that while her database analyses information supplied by Managed Account Reports, a New York company that looks at money under management, it is of concern that not all funds report their latest results in every quarter. "Perhaps they are reluctant to report during quarters of particularly poor financial performance, which skews the database in favour of healthier average returns." In the six months under review, 1 453 funds managing $283-billion are analysed. "A further $15-billion is associated with funds who failed to report on the June quarter," says Cross, confident that while the sample is perhaps only a tenth of the estimated amount of money under management through 4 000 funds, the trends identified represent the whole industry. Cross comments on the large amount of new money flowing into the funds: almost a fifth had more than doubled the amount under management at June 1998 than at December 1997 and only 26% showed reductions, most of them CTAs. Cross notes the speed at which the Federal Reserve Bank acted to head off the potential default of Long Term Capital Management. "Banks and financial authorities have already had a wake-up call which will almost certainly result in much more stringent credit limitations and the ability to borrow for leverage." Indeed, it would be surprising if LTCM were the only one of some 4 000 funds to experience difficulties. "There are already signs of the losses eroding away some of the long-standing averages. Only 48 funds managing $4.3-billion now enjoy average returns of more than 50% compared with 178 funds managing $10.6-billion at the end of December 1997." Cross investigated the rate at which investors could withdraw money from the funds. "We would say that 32% or $84-billion of our sample is not at all liquid: the money requires a minimum of a month's notice, then a wait of at least another 60 days. Another $40-billion requires at least a month's notice followed by a couple of weeks' wait before the money is released. "If these figures are representative of the industry, we can expect a substantial time delay of months or more between a shock to the system sufficient to cause investors to give notice and the actual drain of liquidity out of the system." Cross says it is impossible to generalise about the industry's leverage and real levels of exposure. "However, as the hedge fund business is highly geared both through borrowings and the use of derivative products, one must expect the true level of cumulative exposure to markets to be an order of magnitude greater than the amount of money under management. Consequently, any possible default or destabilising ripple-effect in any one market is potentially much greater than the raw data would suggest. "Virtual Gold believes the anticipated review of credit lines is long overdue, very necessary and, for the authorities associated with the global financial world, probably very welcome. Hopefully, it will instil a self-regulating sense of proportion and financial sobriety in an industry which to date has shown little concern for the long-term impact of its collective presence and actions." Cross concludes that while such self-regulation is likely, greater disclosure on the part of the funds themselves - which would go a long way towards bringing a sense of balance into the market - is something for which we can only hope. So what might be the outcome for gold? Rumour had it that LTCM had borrowed and shorted as much as 400 tons in the gold market; Cross questions whether LTCM had the charter to take gold and even if it had, this "position" was never reflected in the cost of borrowing gold. However: "Gold could benefit from further fund defaults if they occur and there is a serious erosion of confidence in the paper world of money, that is, a system shock."
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"Ultimately, someone, somewhere, is left holding a loss-making strategy," says Cross. "There is a limited number of chairs when the music stops. That tail-end of a fund chain will be a lossmaker. Virtual Gold's statistics suggest this is exactly what happened to many commodity trading advisor funds (CTAs) during the first half of 1998."