Beware Of Hedge Funds Bearing Small Caps

Date: Friday, April 20, 2007
Author: Institutional Investor - Dailyii

The attraction of small caps to hedge funds may be cause for worry, according Reuters. "If the stock market plummets and [hedge funds] want to get out, [investors] could get hosed," Tabb Group senior analyst Adam Sussman told Reuters. As reported earlier, short sellers – hedge funds among them – have been piling into small caps in recent years because overall they have been outperforming the general market. But recently Lehman Brothers published a report that raises some concern. In it, the investment bank indicated that in one year alone, hedge fund investment in U.S. equities rose 19% to nearly 4% share of the market, and that "the percent of float held in some small-cap ranges grew by 40% year-over-year," data Lehman gleaned from regulatory filings. "When there are illiquidity shocks, as occurred in October 2005 and May 2006," Lehman wrote in its report, "hedge funds will likely experience worse-than-expected losses simply on their equity exposure and small-cap bias." Reuters makes the point, however, that this doesn’t mean investors should fear a major fall just because of HF investment in small caps. One HF analyst told the news service that it depends on strategy and holding period, among other factors; in other words, a market decline does not automatically trigger a hedge fund sell-off. However, there will be hedge funds that will get socked because of the extent of their bets. Says Ron Papanek, director of strategy at RiskMetrics, in a Reuters interview, "Hedge funds are always looking for an edge, so it’s no surprise that they are looking at stocks that fewer people are looking at. But the lack of liquidity does potentially increase their risk when they need to get out."