From the June 2005 issue of Investment Advisor • Subscribe!

The Chilling Effect of Rumors

This year marks the seventh anni-versary of the Long-Term Capital Management meltdown, but the shadow cast by the collapse of the highly leveraged bond hedge fund is still big enough, and dark enough, to send a chill through world markets.

It happened again most recently in May, when a mere rumor one morning that several hedge funds' bond portfolios had been hit with losses following S&P's downgrade of General Motors Corp. debt apparently was enough to spook the Dow Jones Industrial Average to a 103.23-point loss, around 1%.

The following morning, the financial papers played the hedge-fund angle high, although none of them was ever able to substantiate the rumors, and the hedge funds involved denied they had suffered GM-related bond losses. To their credit, most of the major papers dealt with the hedge fund rumors in their leads, or clearly identified the hedge fund concerns as rumors in the headlines. The exception was USA Today, which in its online edition slapped this headline on its market wrap story: "Hedge fund missteps hit stocks hard."

Although the story itself alluded to the losses as rumors, research and casual conversation has in the past revealed that sometimes people never get past headlines, which in this case could leave those people with the impression that hedge funds had misstepped when in fact that was only rumored to be the case. Of course, USA Today has not yet become the go-to source for market news among knowledgeable people in the financial industry, but with a circulation of around 2.2 million, it is clearly a major source for news--including business news--for many Americans. Seeing a headline about hedge fund missteps associated with the following day's market decline likely confirmed the suspicions and vague mistrust of hedge funds held by those who heed the headlines.

Historically, hedge funds and rumors have gone together like twisters and trailer parks. Hedge funds can make for easy targets, since at least among the general public they are shrouded in mystery, and mainstream news reports often don't do much to demystify them.

Of course, hedge funds don't always help their own cause as they generally do not disclose their positions and do not comment on rumors, or sometimes much of anything else, to reporters.

The result is that it doesn't take much to start a hedge fund rumor. To understand how it spreads, one must understand traders and reporters. Some traders have proven they will sometimes say things they either: (a) don't believe; or, (b), believe but can't really prove in order to turn a profit. Some reporters have proven they'll: (a) believe almost anything told to them by someone they trust; or, (b) print things they don't really believe in order to get a scoop.

It seems clear regulators hope greater transparency in the hedge fund industry will reduce the chance of another LTCM-like blowup. Last month, U.S. Federal Reserve Board Chairman Alan Greenspan warned that so-called "hot" institutional money flowing rapidly into hedge funds could strain financial markets if it suddenly pulled out of hedge funds, forcing the funds to sell into falling or illiquid markets. Such a setup could lead to more widespread difficulties for financial markets, Greenspan said.

If last month's hedge-fund-inspired selloff proved anything, however, it's that it might not take an actual liquidity crisis to strain the markets; The mere rumor of one might do the job.--Chris Clair and Jeff Joseph

Chris Clair is a senior reporter at Hedgeworld; Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a question about hedge funds? Feel free to contact Jeff Joseph at jjoseph@rydexfunds.com.

For inquiries about HedgeWorld's services, e-mail inquiry@hedgeworld.com.

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