The recent wild swings in stocks and other markets, including some of the biggest point losses and gains ever seen in the Dow Jones Industrial Average, are widely attributed on Wall Street to shadowy hedge funds experiencing big losses and forced sales that have the power to move entire markets.
Thousands of hedge funds, which serve mostly wealthy clients and have only recently been required to report their secretive trading activities to federal authorities, are in the midst of a monumental rout spawned by the global financial crisis. Many investors are pulling out their money after suffering record losses of 10 percent on average so far this year and, for some funds, as high as 30 percent. Some analysts predict that as many as half of hedge funds with nearly $2 trillion under management will fail or be closed in coming months.
But they're not going down without a fight, and leaders from Washington to New York are worried that some gigantic funds could flame out in spectacular fashion and dangerously roil already racked markets.
"People are nervous," said Robert Elliott, senior managing director at Bessemer Trust. "If we have roughly 8,000 hedge funds now, we might see 4,000 by the end of next year. ... Hedge funds could be the next hiccup, and people could say this is another example of poor regulation."
David Dietze, president of Point View Financial Services, said the market made whipsaw moves in the past month as highly leveraged hedge funds and mutual funds were forced to sell positions to meet margin calls from their lenders and demands from shareholders for the return of their money.
Hedge funds get their loans from Wall Street firms and are the most highly leveraged market players, with leverage ratios as high as 60 for every dollar of cash invested. But the credit crisis has made it harder for the hedge funds to get loans, and they're being forced to sell even winning positions in some investments to reduce their debts and holdings.
"These hedge funds are getting hit by redemptions, their credit lines are being pulled and they are having to sell furiously," Mr. Dietze said. "Selling begets selling, which begets selling, which begets more selling."
One result is an index that measures volatility in the stock market has reached a record seemingly each day in the past month. On some days, the Dow fell several hundred points in the morning and then staged a near-1,000-point reversal midday that left it up by several hundred points at the end of trading, or vice versa.
Huge gains or losses typically are registered in the final hour of trading, when many computerized buy and sell orders from hedge funds and other large institutional investors are triggered.
"It is hard to pinpoint the dynamics driving the volatility ever higher, but we believe the selling at low levels is mainly led by funds either shorting the market or being forced to liquidate long positions to meet margin calls," said Paul Lennox, corporate treasurer at the Canadian investment firm Custom House, referring to the practice of short-selling stocks through complicated trades that profit when the stocks decline.
Hedge funds are the biggest practitioners of short-selling. Other big institutional investors, including mutual funds and pensions funds, are barred from the risky practice. While short-selling generally drives down stock indexes, short sales sometimes go awry and can generate dramatic gains in the market. When short-sellers get "squeezed" - that is, forced to exit their positions to cover losses - the stocks being sold short suddenly post huge gains.
"At the lows, short positions are being covered and value investors are also stepping in to scoop up quality stocks at bargain prices," Mr. Lennox said, comparing the recent volatility in stocks to the wild ride that hedge funds helped create for oil and other commodities earlier this year.
"Just like the commodities were driven to crazy heights by speculators earlier this year, stocks are getting all the attention now, but on the short side. Hopefully, the speculative hedge funds will soon find a new game and the value investors can establish a bottom to this market," he said.
Bill Gross, founder of Pimco, the biggest bond fund, blames liquidations by hedge funds for "mandating low prices" in stocks, bonds, real estate and other major assets.
While the wide gyrations leave many small investors bewildered, the turmoil generated by hedge funds is creating opportunity for prominent investors like Warren Buffett, who has been snapping up blue-chip stocks at bargain-basement prices. Mr. Buffett, who recently took major stakes in General Electric Co. and Goldman Sachs, said Friday that the low prices are providing a rare opportunity to load up on U.S. stocks that he views as long-term winners.
Hedge fund short-sellers in recent weeks have targeted financial stocks such as the now-defunct Lehman Brothers and Washington Mutual as well as troubled firms such as Morgan Stanley to try to restore the double-digit returns that endeared them to wealthy investors. But now that the federal government is standing behind all the major banks with $1 trillion of capital infusions and other subsidies, they are looking for other targets.
Ironically, among the stocks in the sights of short-sellers now are the handful of hedge funds that are publicly traded, including the giant Citadel group, which has had a 30 percent loss so far this year. Forced sales by Citadel as bets went awry and investors pulled out of the fund were rumored to have helped fuel Wednesday's 733-point drop in the Dow, the index's second-biggest point drop.
Citadel founder Ken Griffin, who earned $2.8 billion in fees and commissions last year, complained in a letter to investors that "September was a devastating month" for institutional funds everywhere and that bans on short-selling by U.S. and European authorities during the month made it "the single worst month, by far, in the history of Citadel."
Hedge funds strenuously opposed the U.S. ban and persuaded the Securities and Exchange Commission to make it temporary, successfully arguing that market volatility during the three weeks it lasted was just as bad as it was when short-selling was allowed. But now that the ban is lifted, hedge funds themselves have become enticing targets because, like the Wall Streets investment banks that were targeted earlier, they have highly leveraged investments in toxic mortgages and they are not protected by the federal bank rescue program.
In an interview with Bloomberg Television last week, Treasury Secretary Henry M. Paulson Jr. ruled out any assistance to hedge funds. He said the Treasury plans to aid only "regulated" institutions like banks and thrifts. Hedge funds through the years lobbied hard to escape regulation - to their detriment, as it turns out.
"Big banks around the world are now mostly backstopped by governments, so the rumor mill has found new grist: hedge funds," said Robert Cyran, an analyst at Breakingviews.com. He said a well-established fund like Citadel should survive the onslaught because it has a leverage ratio of only 4-1 - not as "deadly" as other firms.
"Most of the biggest, conservatively managed funds should pull through. But losses, deleveraging and redemptions could claim a few big scalps," Mr. Cyran said. "Such failures are unlikely to pose the same kind of systemic risk as the collapse of a dealer like Bear Stearns. But even if they did, a hedge-fund rescue would be a tough political sell. Any managers on the brink shouldn't bank on help from Washington."
Far from helping hedge funds, legislators and regulators in Europe and the United States are considering much stricter regulations. Italian Finance Minister Giulio Tremonti recently proposed abolishing hedge funds entirely. But the huge sums that hedge funds contribute to political candidates and lobbying in Washington make it unlikely that would happen in the United States.