4/02/2007

04-02-07 - 2

You may not be aware of it at all, but there are currently thousands of huge private equity hedge funds doing computerized trading on all kinds of markets (stocks, currencies, commodities, futures, etc.), moving billions of dollars. They generally do risk-free or very low risk transactions. These aren't traditional investment funds that put money into businesses they think will succeed. These funds look for "loops" or ways to "bet both sides" , like arbitrage or just plain mistakes. They also take advantage of the different schedules of the markets and the delays of big mutual funds.

What is the real net result of these funds? The funds make a lot of money, and everyone else makes less. The money these guys are making doesn't come out of the air. Then they trade a commodity vs. a future, it's because they spotted a price that was incorrectly too low, and by trading it they drive it up and make it correct, and suck the "slack" out of the system. That sounds harmless, but the slack was a discount for someone buying that commodity which made the goods cheaper. The same thing occurs in stocks - effectively they are "fixing" the prices of various transactions, which always means making them worse for others.

This has been going on for perhaps 10 years, but has really only kicked into high gear in the last 5 years. We won't know the full effects on long term market returns for many years, but already something measurable has happened. Mutual funds that track the major indexes (like the S&P 500) are performing much worse than they used to, perhaps 1% worse. This is happening because changes to the S&P inded are announced in advance, and it takes a while for the mutual funds to shift in, and the hedge funds sit in the middle and make profit.

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