In the recent stock market downturn, several high-profile companies have blamed hedge funds for undermining their shares, writes Deborah Hargreaves.

When stock markets are volatile and share prices are falling, company directors often look for someone to blame. In the recent stock market downturn, several high-profile companies have pointed at hedge funds for undermining their shares.

Leading figures in the City of London such as Mr David Prosser, chief executive of British insurer Legal and General, and Mr David Varney, executive chairman of MMO, the mobile operator, have called for greater disclosure about hedge funds' short-selling activities.

In the United States, for instance, short-sellers on Nasdaq have to indicate the status of their trading, allowing the exchange and investors to keep track of just what sort of trade is going on in particular stocks. This tracking of hedge funds' short-selling trade has yet to take hold in the Irish or British markets.

Hedge funds pursue a variety of strategies, but many of these long/short managers try to strip out volatility for investors in their funds.

They do this by taking long stock positions (buying shares) as well as shorting (selling shares they do not own in anticipation of buying them back more cheaply at a later date) to try to protect their returns in a falling market.

Hedge funds have been one of the success stories of the bear market.

Prof Narayan Naik, director of the Centre for Hedge Fund Research and Education at the London Business School, estimates that more than 3,000 hedge funds have market exposure of about $1,000 billion (€1,006 billion).

Critics of these free-wheeling, fast-moving funds argue that their strategies can create volatility by exaggerating share price movements. Indeed, some institutional investors have called for greater disclosure on short selling, which they say is becoming more aggressive.

The Financial Services Authority, Britain's chief markets regulator, recently published a discussion document about ways to shed more light on the practice.

Stock market volatility has become more exaggerated in recent months - it is not unusual to see a 10 per cent swing in a share price in a matter of days. The VDax, which measures implied volatility in Germany's leading stock index, reached its highest level ever in October. At the same time, the Vix, which measures volatility in the Standard & Poor's 100 index, rose to a 10-year high.

However, many market analysts say it is unfair to blame hedge funds for these extreme levels of volatility. "The effect of life company hedging is much more significant," said Mr Andrew Garthwaite, managing director for global equity strategy at Credit Suisse First Boston.

"Life companies are selling equities in the derivatives market and people on the other side of that trade have to hedge their exposure," he said.

Prof Naik says many hedge funds are taking long/short positions - for example, going long on Tesco and short on Sainsbury - and are betting on the ability of the supermarkets to compete with each other.

"That may actually have a stabilising effect on prices rather than destabilising," according to Prof Naik.

Mr Hugh Hendry, who runs a hedge fund at CF Odey Asset Management, argues that the activities of these managers have supported prices on weak days in the market.

"Perversely, hedge funds are buying on quite bleak days as they come in to cover their short positions and lock in profits," Mr Hendry said.

Other analysts agree that hedge funds have more effect on the upside than the downside.

"They tend to be much more panicky if they need to close shorts rather than open them," said Mr Chris Carter, head of strategy at Investec Asset Management.

This is because if a group of hedge funds has taken out a short position in a stock, they will be swift to buy the shares and close that position if the price looks like bucking its recent trend.

"There can be big jumps in individual prices if a stock has been in a marked or steady downtrend that appears to be reversing," said Mr Carter.

Hedge funds follow share price trends very closely and their actions can condense longer term market moves into a shorter period. "I am more cognisant of what the market is doing and why there is an uptrend - I'm driven into those areas when I find I'm in agreement with the market," says Mr Hendry.

"A long-only manager is not cognisant of the trend, just the last meeting with the company's manager or broker."

It is this trend-following that leads some analysts to criticise hedge funds for not being interested in company fundamentals and for exaggerating price movements.

But Mr Carter argues that hedge funds do follow fundamentals indirectly.

"The idea that hedge funds can establish a trend on their own is not to me altogether plausible and the idea that they can start a trend against market fundamentals is totally implausible."

Prof Naik says that where hedge funds have had a big effect on markets is in convertible bond arbitrage.

"Some 70 to 80 per cent of these issues have been placed with hedge funds and they are all using the same models and responding to the same buy and sell signals, so they can offload at the same time," he says.

Although companies can be nervous about the effects of hedge fund activity, Mr Carter argues that managers do not arbitrarily short stocks or push prices down. But, he adds, "hedge funds might be able to take a stock down further than it might have otherwise gone".

Hedge funds are also a relatively modern phenomenon - the first were set up in the 1950s. This would imply that volatility should be at record levels if these managers were responsible.

However, CSFB has tracked volatility on a monthly basis back to 1920, which shows that current levels were reached on eight previous occasions. These included October 1929, September 1937, October 1974, October 1987 and September 1998.

The good news is that extreme volatility often signals a market low and CSFB points out that on its monthly measure, subsequent market performance averaged 12 per cent over the following year (excluding October 1929) after one of these volatility hotspots. - (Financial Times Service)