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Sagging Stock Market Puts Pressure on Hedge Funds

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Index Jul-04 QTD YTD Description
S&P 500 Index* -3.43% -3.43% -0.92% Large-cap stocks
size=”-2″>DJIA* -2.83% -2.83% -3.01% Large-cap stocks
Nasdaq Comp.* -7.83% -7.83% -5.79% Large-cap tech stocks
Russell 1000 Growth -5.65% -5.65% -3.07% Large-cap growth stocks
Russell 1000 Value -1.41% -1.41% 2.47% Large-cap value stocks
Russell 2000 Growth -8.98% -8.98% -3.81% Small-cap growth stocks
Russell 2000 Value -4.60% -4.60% 2.87% Small-cap value stocks
EAFE -3.23% -3.23% 1.47% Europe, Australasia & Far East Index
Lehman Aggregate 0.99% 0.99% 1.14% U.S. Government Bonds
Lehman High Yield 1.36% 1.36% 2.74% High Yield Corporate Bonds
Calyon Financial Barclay Index** -1.11% -1.11% -4.97% Managed Futures
3-month Treasury Bill 0.54%
All returns are estimates as of July 31, 2004. *Return numbers do not include dividends. **Returns as of July 29, 2004

July was a terrible month for stock investors. Few sectors of the market were left untouched, leaving investors looking to their alternative investments for relief.

Unfortunately, most hedge fund managers didn’t fare well last month, either. They may not have lost as much as the indexes, but the number of funds reporting positive returns will likely be much smaller than the norm. The reasons for such tepid performance, however, are not directly related to the downdraft in stocks.

Take the level of stock market dispersion. This metric, which measures the extent to which the share prices of equities move in different directions, is sitting at a five-year low. As a result, equity prices are moving more in unison than in recent memory, which has transformed long-short equity books in directional market bets. The lack of dispersion made stock picking a nearly fruitless exercise.

Another toxin for hedge fund managers is the decline in trading volume, a situation that makes trading even tougher. To add to the misery, the percentage of volume that encompasses program trading keeps climbing. Although it is not clear that such trading actually reduces the extent of arbitrage opportunities, there is little doubt that market conditions are tougher now than in recent memory.

As for hedge funds of funds, their relative outperformance versus equities caught a huge bit of wind in July. As stock prices fell precipitously–tech stocks lost nearly 8%, as did the small cap sector over all–FoFs lost only a fraction of this amount.

Nonetheless, there is a lot riding on hedge funds this year. As inflows have risen into the now mainstream hedge FoF industry, fee pressures will almost certainly increase if the returns from alternative investments aren’t any better than those from traditional markets. But in order for hedge funds to post a rebound, the declining trends in market dispersion and trading volume must reverse themselves.