Pack Mentality Grips Hedge Funds
Comment of the Day

January 18 2011

Commentary by David Fuller

Pack Mentality Grips Hedge Funds

Here are a couple of samples from this interesting article published by The Wall Street Journal:
An analysis of hedge-fund returns by Andrew W. Lo, a Massachusetts Institute of Technology researcher and fund manager, shows that funds have become more likely to lose and gain money together over the past five years. There is a roughly 79% chance any randomly selected pair of hedge funds will move up and down in tandem in a given month from 2006 to 2010, compared with a roughly 67% likelihood from 2001 to 2005, according to his analysis.

One explanation is that they are focusing increasingly on the same stocks. Last year, for example, stock in Apple Inc. was held by 55 of the nearly 200 large hedge funds tracked by AlphaClone LLC. In 2008, by comparison, the favorite hedge-fund stock, Microsoft Corp., was held by 34 funds.

"The whole hedge-fund industry is a series of crowded trades," says Mr. Lo.

In June, Mr. Lo and other researchers presented a paper to government economists and regulators suggesting that when hedge funds lose money, there has been an increasing risk of a "contagion" of losses rippling through the financial system.


Many hedge-fund managers freely share investment ideas with one another-a practice that might seem at odds with their aspirations to post higher returns than competitors. Fund managers, traders and hedge-fund chiefs exchange ideas through instant messages, emails and private chats.

Sharing ideas can reap financial benefits. When multiple hedge funds jump into the same stock, that tends to push the share price higher-an obvious benefit to the fund manager who got in first.

Such activity isn't legally problematic unless there is an agreement among funds that share ideas to artificially influence a security's price. That kind of behavior can be considered market manipulation, particularly if participants are deliberately passing false information to influence a security's price.

Sometimes, trades stem from "idea dinners," where hedge-fund managers discuss stocks, markets and economic trends.

Last February, for example, research boutique Monness, Crespi, Hardt & Co., organized a gathering of more than a dozen hedge-fund chiefs and portfolio managers in Manhattan. One attendee, hedge-fund manager David Einhorn of Greenlight Capital, touted his investment in CIT Group, according to others who were there.

David Fuller's view In other words, hedge fund managers are social animals, just like most other active investors. They belong to the same clubs, go to the same dinners and conferences, share the same brokers and research services, and view the same reports and price charts.

There is nothing new about the pack mentality which has been around for a lot longer than hedge funds. It is normal. However hunting in packs, in an attempt to muscle a market, which hedge funds and other large speculators occasionally do, is obviously predatory and should be discouraged by regulators, in my opinion.

Inflation and momentum moves in markets - How many times over the last year have you read or heard: "Inflation is dead", and "There is no inflation", or "Deflation is the problem"? Plenty of times, I suspect. Meanwhile, central bankers were standing shoulder to shoulder, pumping out the mother of all monetary reflations, determined to create some inflation. And they are very good at it. Just consider the declining purchasing power of any currency over your lifetime to date.

Our present inflation is very different from the 1970s, at least in terms of wages in the West. The mostly good news is that there is almost no wage inflation in North America or Europe, for one very important reason - globalisation.

How could there be wage inflation in the West's fungible private sector jobs when there are plenty of people in emerging countries willing and able to perform the same tasks for much lower wages? The public sector still has some bargaining power but often at the cost of jobs and there is very little public sympathy for strikes in most countries.

Those of us in need of increased earnings must work harder at the day job and try to earn bonuses. And some of us use our wits and skills to profit in the markets. You may feel poorer in terms of salary, as I do, but low wages are mostly good for corporate profits. There are also opportunities in other markets, not least commodities, as Fullermoney has pointed out for a decade.

Our current inflation rhymes with the 1970s in terms of commodity prices, although this cycle will almost certainly be stronger. After all, the global population is much larger today, and the adoption of capitalism in its various forms by most countries has empowered many more people. Consequently, the global demand for commodities has never been greater.

Fortunately, the commodity markets commenced this supercycle approximately ten years ago from extremely depressed levels in both nominal terms and especially in real terms. For instance, here is the Continuous Commodity Index (Old CRB), which you have seen before, in nominal terms. Now look at the same Index adjusted for US CPI inflation. It has seen a significant rise but from an all-time historic low less than a decade ago. More importantly, it is no where near the 1970's peaks today, but I would not bet against them being taken out during the current decade.

Meanwhile, commodity prices continue to rise in a series of momentum moves, driven by economic supply and demand, plus speculation. Precious metals have received most of the headlines because they were the first to rise and have seen some of the biggest overall gains.

However, since mid-2010 a much bigger percentage move has been occurring in the grain and bean complex. Risks inevitably increase as trends progress but judging from the charts, this momentum could very easily have further to go before a significant retracement occurs. Here are the four main contracts:

Corn (weekly & daily) has been volatile at earlier stages of this uptrend (prompting me to take my latest profits too soon last Friday) but that may be changing as the advance gathers participants. A break beneath the last reaction low near $5.95 would now be required to check current upside momentum beyond a brief pause.

Rough Rice (weekly & daily) had been ranging in a symmetrical triangular pattern since last November but today's limit up move indicates that it could soon break to the upside, following corn's current lead. A close beneath the last reaction low just under $13.5 would be required to negate the current prospect for additional gains.

Soybeans (weekly & daily) remain steady following the break above $14 and a close beneath the last reaction low near $13.55 would be needed to check momentum beyond a brief pause.

Wheat (weekly & daily) has underperformed since its initial surge last July. However this pattern resembles a lengthy first step consolidation above the base and a close beneath last week's reaction low near $7.58 would be required to question current scope for a sustained break above the psychological $8 level.

Here are some related articles from Bloomberg:

Corn Futures Climb to 30-Month High on Rising Demand for Shrinking Supply

Wheat Rises to Two-Week High as Adverse Weather May Hurt China, U.S. Crops

Rice Stockpiles in Vietnam Decline by 41% After Record Exports, Group Says

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