Doug Kass: Hedgies Get their Comeuppance

I'll reproduce Doug Kass' comments in full here since it is on the free portion of TheStreet.com. Doug is founder of hedge fund Seabreeze Partners and one of the few voices of sense (when he appears) on financial TV.

I am with him on these comments and have said early in this blog life at some point these huge concentrated pools of capital moving so quickly in and out of "everything and anything" are going to cause major dislocations in world markets. But I did not imagine it for quite a few more years - the amount of "actual" money they control is not "that" huge in the big scheme of things. But since I am not in the business and clearly did not realize the amount of leverage in our system; it is immense - I underestimated how much entanglement they already have. My hope is enough hedgies break down during this period that they are eliminated from the equation and their investors question what the heck they are paying those fees for. The good managers should remain and prosper - but these guys levering up 20 to 1, 10 to 1, 30 to 1, or whatever to create return - I hope many just are cleaned out so that this market can trade on some semblance of fundamentals again. I think leverage made a lot of people look a lot smarter than they really are.

Now one of the worries I am hinting at here today is what happens if multiple hedge funds (who are paid 2% of assets plus 20% of profits in most cases) simply give up in the fourth quarter and purposefully go out of business? That in itself could cause major selloffs in the market. Why would they go out of business on purpose? Because they don't get paid that 20% until they make their shareholders whole. So for example if they are down 15% this year - and someone invested $1M and was down to $850K, if next year they make 10% and get that account back to $935K they don't make that 20% fee next year. They have to get back to $1 million before they start making the 20% again. So why bother? Just shut the fund down, return the money to shareholders - sit on your rear for 6 months then announce your "starting anew!" raise a whole bunch of capital and you have a clean slate and can begin making your 20% of profits again. And since "savvy" investors seem to go to the same well over and over - I guess it works. But what does that mean for us? If... and it's a big if... a lot of hedge funds close up shop in the coming few months their positions must be unwound. And unwound with leverage.... meaning indiscriminate selling. And in a globe that is deleveraging that is right now, something that could be quite nasty. We'll see how it plays out but the rumors are already starting out there.... funny, some hedge funds start rumors (allegedly) to drive companies stocks down - and now the table is turned on them. Again, I love irony. But these guys are complete sharks and any hint of blood in the water will cause one to turn on the other. And you thought this was a simple market where stocks trade on fundamentals or something? Hah, that is so 1990s.

• Speculation sweeping the market that large hedge fund Atticus Capital is liquidating its positions and closing down is not accurate, according to executives of the firm. "We've heard these rumors as well and they're not true," says Tim Barakett, founder of Atticus, which has about $14 billion under management. "We're certainly not liquidating. In fact we have a large net cash position and are looking for opportunities to invest capital."
• Part of the reason stocks tumbled Thursday was selling by hedge funds who are trying to get out of positions they fear fellow hedge funds, such as Atticus, will sell if they are under pressure to close shop or trim losses. Some are trying to make money shorting stocks held by struggling hedge funds, traders say.
• "Hedge funds that picked on Lehman Brothers and Bear Stearns now are picking on each other," said the head of prime brokerage at a major investment bank. (classic, just classic - see they will do ANYTHING to make their fees. Anything.)
• A number of hedge funds are nervous that their investors might ask to pull out in the weeks and months ahead, amid a disappointing year for many funds. That's sparking anxiety in the market.
• Atticus, however, says its investors are largely sticking with it, despite losses of between 25% and 32% in its two main hedge fund this year, through August, according to investors. Losses this month have not been dramatic, these investors say. (remember, these are the best of the best investors in the world - losing 1/3rd of their money - and are supposed to be "hedged" - a lot of those "simpleton managers" at mutual funds are doing better than losing 1/3rd of their investors money in 8 months - what did Buffet say about when the waves pull back, the naked people are exposed? ;))
  

**************************** Kass' article below

Like the Dukes who tried to corner the market in frozen concentrated orange juice in the film Trading Places, the hedge fund community is getting its comeuppance now.

For now, as in that fictional 1983 when the Secretary of Agriculture gave the pronouncement in Trading Places that the cold winter apparently is not affecting the orange crop, our commodity and stock markets, too, are in disarray and in liquidation mode.

Today, as equities and commodities slide, the risk managers have taken over from the portfolio managers. And those risk managers are selling posthaste regardless of a sense of value, the relationship of stocks to interest rates, etc. -- just as the movie's orange traders did 25 years ago.

I have long thought that the most dominant investors in the land -- hedge funds, many of which have taken abnormal risk in producing normal returns over the past several years -- would face the liquidity event we are now experiencing. And I remain of the view that a renewed level of instability in the levered (and often uninformed) fund of funds community is exacerbating liquidations.

All the way back in 2006, I cautioned that the hedge fund industry's dirty little secret was the excessive use of capital, which displaced old-fashioned stock picking as a means of generating excess returns, and that the unnatural growth in hedge funds was sowing the seeds of its own destruction. Accompanying this were the risks to their disintermediation and an eventual market selloff. While this became a growing secular market concern to me two and a half years ago, its timing was uncertain.

It was, after all, a new era yet again! But as investors learned in May, it created a false sense of security.

A vicious cycle was created as the appetite for risk turned into its own bubble. Generally speaking, investors (especially of the fund of funds kind) cared little about how returns were generated. Rather, they focused solely on the level of the returns that were generated.

And hedge funds complied by stacking cheap debt upon their equity bases in all sorts of carry trades (funding longer-dated assets with shorter-term liabilities). Many hedge funds even stretched reason by selling tons of volatility -- after volatility had fallen to record low levels.

-- Doug Kass (June 1, 2006)

Since the beginning of the decade (and possibly earlier), we have witnessed the morphing of the hedge fund industry into a dangerously levered capital pool. As Randolph Duke reminded us in Trading Places, they took a "perfectly useless psychopath like Valentine, and turned him into a successful executive. And during the same time, we turned an honest, hard-working man (Winthorpe) into a violently, deranged, would-be killer! (laughs)."

In 2007, I warned about the consequences and the volatility that would follow the unwind and disintermediation of the hedge fund industry.

In January 2008, in my surprises list for 2008, I further discussed the liquidation scenario that is now ever-present:

17. The hedge fund community (especially of a quant kind) is disintermediated in 2008. Outflows accelerate, abetting an already conspicuous trend of rising volatility in a market that behaves more like a commodity than ever.

-- Doug Kass (January 5, 2008)

Finally, yesterday I discussed the same in the Wall Street Journal and on RealMoney Silver.

The Dukes traded in orange juice; the hedge funds had an overzealous love affair for materials/energy stocks and commodities. Both took their markets higher until the music stopped (for the movie's orange market, 25 years ago; for stocks, several months ago).

Over the last few days, the panic in the hedge fund industry has become as thick as the fog rising from Shinneock Bay in the Hamptons this morning. Fear of rising losses and redemptions (especially of a fund of fund kind) has many opportunistic hedge funds sitting on their hands in a buyers strike as those that are levered are being forced to sell.

What we are now experiencing is not only a flight to quality (into Treasuries) but a flight period -- that is, an unwind out of stocks, out of the carry trade, out of commodities, etc. -- and for many investors/traders, they are out of luck.

As I suggested (albeit prematurely) yesterday, this is the sort of capitulation that always marks a market bottom.

As it is said, it is always darkest before the dawn, as it was for bank stocks on July 14, 2008.

I suspect that the smart and liquid investors, like Berkshire Hathaway's (BRK.A - Cramer's Take - Stockpickr) Warren Buffett, though not yet visible, are likely committing serious monies on the other side of this week's liquidations or are getting their ducks in a row to buy in order to capitalize on Mr. Market's sale. They will be greedy when others are fearful, and, in the fullness of time, they will likely record outsized gains out of today's carnage.

But for now, as the Duke brother screamed, "Where's Wilson (the hedge funds)?"

They are selling Mortimer.