Do Hedge Funds Create and Burst Bubbles for their Own Benefit?


In recent years, hedge funds have become dominant players in the investment markets and the evidence suggests that hedge fund trading (which regularly involves thousands, if not hundreds of thousands, of shares) has been a significant contributing factor to market volatility.

For example, hedge funds have been major buyers of gold and silver for two years. Precious metals can provide a hedge against inflation under certain circumstances. Some like silver also tend to be cyclical as demand is related in part to their use in various products. Hedge funds helped to drive the price of gold and silver to historic heights.

Recently, however, the stampede into gold and silver seems to be over for the moment, and hedge funds are leading the charge out of gold and silver. Accordingly, the gold and silver markets sustained significant losses. Thus, while the bubble that hedge funds helped to create may be in the process of bursting, they have already reaped big profits on their investments.

Hedge funds are also big buyers of alternative investments.

Alternative investments include a variety of non-conventional securities. Examples include structured products, private equity funds, non-traded (private) REITs, derivatives (e.g., futures and options contracts), credit default swaps, CDOs (collateralized debt obligations, asset-backed securities, exchange traded funds, variable annuities, equity indexed annuities, private (Reg D) offerings, high yield (junk) bonds, preferred stocks, leveraged funds, and gold, silver and other precious metals funds. Hedge funds are themselves alternative investments.

Hedge fund assets reached $1.8 trillion in the first quarter of 2011, their highest level since October 2008. Much of the new money reportedly came from pension funds seeking alternative investments.

Hedge funds tend to be active traders, which leads to increase trading volume. Money flowing into hedge funds has a larger impact on trading volume than it would otherwise have had.

Conversely, money flowing out of hedge funds sparks selling to raise cash. This selling tends to be done in assets that have gone up the most, like gold and silver.

Investor money has been flowing out of hedge funds lately. If things get really ugly like they were in 2008, there could be a run on hedge funds, and a resulting run on every traded asset, starting with the biggest bubbles and working down from there.

Hedge fund trading is big enough to destabilize markets and can be abused. Yet hedge funds are unregulated and their activities are not transparent. Although it is unlikely to happen any time soon due to political paralysis, hedge funds need to be made subject to federal regulation and oversight to protect the financial system. Unfortunately, we may soon see the consequences of the failure to do that.

Page Perry is an Atlanta-based law firm with over 150 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 45 occasions. Page Perry’s attorneys have extensive experience in representing investors in cases involving hedge funds and other alternative investments. For further information, please contact us.