Investors with plenty of cash on hand, thanks to years of low interest rates, have flocked to illiquid investments in search of outsize returns, often with the help of borrowed money. Some market experts worry that investing in illiquid assets, despite their inherent risks, has become almost mainstream.
In 2006, U.S. institutions such as pension funds and endowments, had about $1 of every $10 invested in less easily traded assets -- such as hedge funds, real estate and private-equity funds -- up 27% from 2003, according to consulting firm Greenwich Associates.
The article also notes the use of leverage heightens the problems of the funds if the investments lose value.
These two paragraphs succinctly explain why hedge funds have risen in popularity during this market rally. Low interest rates have driven investors from traditional fixed-income based investments like money market and bond funds. Additionally, hedge funds have an allure of sophistication that makes them more attractive. Think of this as the "keeping up with the Jone's" in the investment world. Put those two factors together and you have a situation that is ripe for the increased use of hedge funds.
However, there are two problems here. The first is illiquidity.
The Bear Stearns funds, whose investors include wealthy individuals, other hedge funds and some of the firm's own executives, are part of a recent boom in investment vehicles specializing in illiquid assets, such as exotic securities, highways and timber lands.
Unlike stocks or bonds listed on an exchange, such assets can't be readily bought or sold. That makes it hard to establish an accurate price for them. Fund managers have broad discretion in attaching a value to these assets, and often don't reveal many details of their trades.
As someone who trades fairly regularly, I take liquidity as a given -- as I think do most people. We all expect to be able to sell our assets quickly if we need to. However, not all markets are liquid for a variety of reasons. The Bear Stearns' funds assets were illiquid for two reasons.
1.) The size of the funds. Managers don't just sell $3 billion is assets in a minute. A trade that large takes a few days at least. In addition, a trade that large alerts the street there may be a problem with a particular asset or market area.
2.) The type of securities. From what I have read, the Bear Stearns fund invested in the more illiquid portions of CDOs. If this is an accurate read, the fund has the distinct problem of needing to sell a large quantity of illiquid, under-performing assets. This is a classic example of lack of diversification.
Finally, there is the issue of leverage. Some hedge funds borrow money to increase their returns. However, increased leverage works the same way in bullish and bearish markets. While I am personally content to let people and institutions do what they want to with their money (however stupidly), here we have a really big problem. 9 to 1 leverage amplifies gains and losses. With this fund we have a loss of 20%, amplified 9 to 1 because of the mammoth amount of leverage. It looks to me that the manager didn't even consider the possibility of a loss. And that's where the real problem lies. This funds lack of forethought hurt the whole market.
