Hedge funds Collateral damage

Economist – Hedge funds are supposed to hedge. This year, they haven’t. The fund-weighted composite index compiled by Hedge Fund Research, a firm that tracks the industry, fell by 4.7% in September, the second-worst month on record. Since the start of the year it has lost 9.4%. The industry’s promises of “absolute returns” for investors now ring rather hollow.

To be fair to them, hedge funds have not been allowed to hedge. The restrictions on short-selling (betting on falling prices) imposed by regulators round the globe have played havoc with managers’ strategies in recent weeks.

Take the worst-performing strategy, convertible arbitrage, which lost the average fund 12% in the month. Convertible bonds are fixed-income securities that can be exchanged for shares in the issuing company. Historically, these bonds have been underpriced, because too low a value has been placed on the right to convert them to equity. So arbitrage managers have tended to buy the bonds and sell short the shares. Thanks to the Securities and Exchange Commission’s ban on the shorting of more than 900 stocks from September 19th to October 8th, that strategy no longer worked. And since the managers could not short the shares, they had to sell the bonds. As a result, the bonds’ prices plunged.

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