By: Allan Sloan, Newsweek
Published: October 30 Issue

Newsweek’s Allan Sloan, “The Cruncher”, offers up some pretty weak evidence this week that a bubble exists in hedge funds:

“Day after day, I hear about hedge funds’ growing power—we’re up to almost 9,000 funds with $1.225 trillion in assets, according to Hedge Fund Research, from about 3,600 with $456 billion at the start of 2000. To you, this may mean they’ll grow forever. To me, it feels like something bad’s about to happen.”

Firstly, as we have discussed on this blog, the industry became quite concentrated between 2000 and 2006 (as the mutual fund industry did years earlier).  As several respected institutional investors have told us recently, there are really only about 700-1,000 funds that would make it onto an institution’s investment radar screen (not 9,000).  And according to research by Alpha Magazine, large segments of the industry actually shrank between 2004 to 2005.

Second, unlike most industries, the investment industry grows organically under its own power (i.e. through investment returns).  For example, the HFRI fund-weighted hedge fund index rose about 65% from January 2000 to September 2006.  A back-of-the-envelope analysis shows that $465 billion can become $767 billion without one new dollar entering the industry.  The remaining $457 billion of industry growth over 5 years amounts to about $90 billion/year or about 15% annual growth in new assets.  This kind of growth in a new industry is hardly a bubble.  In fact, between 1979 and 1998, the US mutual fund industry grew at a rate of 30% per annum.  Strip out organic investment growth of about 12% and you would get a growth rate that is comparable, if not slightly higher, than the hedge fund industry’s growth rate since 2000.

We’re not sure what mystical feeling Sloan gets that “something bad is about to happen”.  But as he suggests, we don’t share it.

Curiously, he’s okay with the price of housing though.  No bubble there:

“Since I’m writing about bubbles, why haven’t I mentioned housing? Because while prices in some markets are still overheated, I don’t think it’s a bubble. The S&P and Wilshire dropped 50 percent in 19 months. Oil and natural gas have fallen sharply overnight. I don’t think anything that deep or fast is on tap for house prices.”

If you think hedge funds are highly leveraged, take a look at housing.  Assuming a 75% mortgage, a home-owner will loose 50% of their equity if prices were to fall only 12.5%.  And yesterday’s Financial Times contained an interesting article called US House Prices Fall Steepest Since 1970.  Here are a few other tidbits from today’s headlines:  Housing Slowdown Should Usher in Gloomy US GDP,   Housing Leads to dip in GDP,  New Home Prices Falling, and Fast.

Hedge funds may be a new model for investment management or they may never live up to the hype (they will probably be both).  But to suggest that healthy industry growth must be the harbinger of a bubble is paranoia.  We believe this is another in a long line of hysterical articles about the “power” of hedge funds (Sloan’s word).

At the end of his piece, Sloan almost sounds a little bitter that the public hasn’t lined up behind the media’s attack on alternative investments:

“A final thought. Excesses in alternative assets don’t involve you directly because you’re not a public or corporate pension fund or an endowment. But if you’re a taxpayer or you plan to retire with a pension or to pay college or graduate-school tuition sometime, your money’s in this game indirectly. I thought you’d like to know.”

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