Thematic Perspectives

“The typical long/short hedge fund has about 67% of its assets in small and medium capitalization stocks, according to a study by Morgan Stanley. A long-only institution has only 35% in these stocks. Most brokerage firm strategists believe that larger-capitalization stocks are undervalued today. If they start to outperform, hedge funds will either have to change their exposure to large-cap issues or risk lagging in relative performance.”

Byron Wien
“There is No Hedge Fund Bubble”

As noted on my blog last Thursday, mega and large cap have outperformed the Smids on a one-year basis. Moreover, as the chart on page 2 shows (see report), Large Cap Value tops the size and style performance list. However, as also noted last Thursday, the Smids have resumed their leadership roles over the most recent periods and are on the verge of making up the ground lost to their large and mega cap brethren due to last spring’s mini market meltdown.

As Byron’s comments note, the Smids are the main beneficiary of unregulated hedge fund money as performance pressures drive their investment decision-making. As I pointed out several weeks ago, much of this has to do with an increase in risk appetites. And so long as performance justifies actions, I would expect nothing to change. Until it changes on a more sustainable level.

Therefore, as with many comments made in early March, the demise of the Smids seems premature. Risk aversion had returned for the briefest of periods (a few weeks) and then it was back to business as usual.

Investment Strategy Implications

This market has parabolic melt-up written all over it. And a key driver is the liquidity flows that are so abundant around the world. Globalization has wrought money flows that find their way into many assets (financial and real) in our borderless world. While Financial Innovation has produced new, powerful instruments, such as hedge funds and private equity, that utilizes the highly liquid fund flows.

Byron’s views help put things in perspective. As he states in his commentary, “hedge funds represent an evolutionary step in money management. They are here to stay and the funds under management are likely to continue to grow larger over time.” When coupled with that other juggernaut of unregulated money, Private Equity, the game has most definitely changed.

As long as liquidity remains abundant and valuation justifications can be found, performance pressures and competition will likely drive financial assets higher. However, make no mistake: the liquidity game can turn on a dime. Put differently, downside volatility can alter the market’s direction fairly quickly, as the largely unforeseen market drops of last May/June and late February/early March demonstrate.

The dynamics of the markets have changed. And unregulated money is at the forefront of that change.

GEM (government, economy and the markets) Implications

The impact of unregulated money on the real economy and the markets are strong and obvious. Tied in with liquidity and leverage, the impact has and will continue to be felt for the foreseeable future. In both directions. When, not if, the political dimension comes into play will depend on when, not if, a major financial crisis erupts.