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Hedge Funds Might Worry Where the Volatility Went: Chet Currier


Date: Tuesday, November 30, 2004

Nov. 30 (Bloomberg) -- In this strange year of 2004, many of the big news stories have been about what didn't happen. Contrary to widespread concerns, terrorists didn't strike before Nov. 2 to disrupt the U.S. elections. Neither did the lawyers afterward. Deflation and inflation both failed to derail the world economy. In defiance of what all the smart money was sure would happen, rising interest rates didn't knock the bond market for a loop. So it's only fitting that the stock market produce a ``didn't'' story of its own. Volatility -- the frenetic fluctuations that seemed to have become a standard feature of modern stock-market life -- did an abrupt vanishing act. After a nine-year run of two-digit swings up and down, the Standard & Poor's 500 Index has shown only single-digit changes all through 2004. Since 1995, the index's annual percentage changes have been up 34, up 20, up 31, up 27, up 19, down 10, down 13, down 23 and up 26. Over the last 60 years dating back to 1944, according to my Bloomberg, the index has had only 17 years in which it rose or fell less than 10 percent -- the last being a 1.5 percent decline in 1994. Supposition Some ``quiet'' years are quieter than others. No one who lived through 1987, which wound up with a 2 percent net gain in the S&P 500, has forgotten the run-up in stock prices through the first eight months of the year, followed by a crash in October. This year has seen nothing of that sort. At no point through late November has the index shown a net change from Dec. 31, 2003, of 10 percent. Even if the rally that began just before the U.S. election carries the index to a net gain of 10 percent in the remaining few weeks, the year will go into the books as the least volatile in a decade. Among the calm stretches in the past, none lasted more than two or three years. As a result, many people have come to count on volatility as a constant. But that surmise, like most assumptions born of familiarity in the markets, may not be as safe as it appears. Many elements of the financial-services industry thrive on volatility -- commission brokers, market-making dealers and short- term traders of all sorts. Elusive Prey Volatility's most notable new constituency is the rapidly growing hedge-fund industry, many of whose members invest in ``long-short'' style. The idea is to reap a reward, known in the trade as ``alpha,'' no matter which way markets are moving. Alpha doesn't come easy. It doesn't accrue naturally to anybody, the way long-only investors benefit from bonds' interest payments and stocks' inherent tendency to rise as economies grow. Generally, alpha must be gained at the expense of someone else, in a zero-sum game. For an ample supply of alpha, it helps to have plenty of volatility. And that's where a low-volatility environment like the stock market in 2004 raises some provocative questions. As more and more hedge funds go in quest of alpha, are they in danger of hunting it to extinction? By seeking to capitalize on volatility, could they cause at least some of that volatility to disappear? Poor Portent One set of hedge-fund performance measures, the Van Hedge Fund Indexes, shows an average return of 3.3 percent for the first 10 months of 2004. That lags a bit behind the average gain of 3.4 percent over the same stretch for all U.S. mutual funds tracked by Bloomberg. It can't be a good sign for hedge funds if mutual funds, most of which invest on a long-only basis, beat them during a period when the stock and bond markets haven't made much progress. By rights, those conditions ought to favor hedge funds. Markets are famous for refusing to provide what the majority wants from them. When everyone is bullish, for instance, prices may be ripe for a decline. So when more and more investors seek to profit from volatility, it would be very much in character for markets to turn less volatile. In the great scheme of things, there is much good that can come from lower volatility -- including better sleep at night for the typical long-term, buy-and-hold investor. For those who make a living from market turbulence, though, it might be cause for bad dreams. To contact the writer of this column: Chet Currier in New York ccurrier@bloomberg.net. To contact the editor responsible for this column: Bill Ahearn at bahearn@bloomberg.net.