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Economy

Itsuo Toshima: Hedge funds, oil money may rock markets in 2015

Hedge funds are going to get some company this year from well-financed groups with oil money. It might be enough to alter the global flows of capital, and investors -- no matter where they are placing their bets -- will have to consider both forces when trying to figure out which way any market will go.

     Pension funds and wealthy individuals are increasingly moving away from hedge funds. Last year, hedge funds made three critical mistakes:

  • They shorted U.S. Treasurys thinking yields would go up.
  • Not expecting benchmark indexes to hit record highs on Wall Street, they locked in gains early on.
  • They bet that companies would continue to drive buyouts in countries offering low corporate tax rates -- and lost when U.S. authorities stepped in to regulate the practice.

     With hedge funds performing worse than U.S. stocks, public pension funds in the U.S. and the Netherlands decided to stop letting them manage their money. With wealthy individual investors following suit, hedge funds now have little choice but to take big risks.

     Call it a Catch-22. Sovereign wealth funds and other groups financed by oil revenue also find themselves with less capital to manage. As the price of crude oil continues to tumble, some analysts have begun to predict that the price will sink below $40 a barrel.

     Oil-producing nations in the Middle East have likely begun dipping into their government-affiliated funds for capital. With the price of their main export in free-fall, they are having to shrink their government-managed long-term portfolios. They first began selling off their holdings of U.S. and European stocks. They are also eyeing the money they have in Japanese stocks. At some point, they will likely liquidate their real estate holdings.

Another Wall Street?

The Abu Dhabi Investment Authority is reportedly enhancing its trading activity. And like hedge funds, the government-affiliated fund in the United Arab Emirates is trying to maximize its investment returns by taking bigger risks.

     Government-affiliated funds in oil-producing countries manage a much more massive amount of capital than private funds. They are encouraged to take risks and can drive share prices all around the world.

     Their key traders are foreign professionals, including some who lost their jobs on Wall Street after the Lehman shock.

     The U.S. now restricts how leading investment banks trade on their own accounts. The Dodd-Frank Wall Street Reform and Consumer Protection Act has prompted many investment banks to scale down or close their proprietary trading operations. With less market liquidity, hedge funds and the big oil money groups are expanding their influence in setting market prices.

Can't make sense

U.S. data for December shows job gains and an improved unemployment rate. But scratch beneath the surface and you will find a decrease in average hourly earnings and the civilian labor force participation rate edging down.

     With many market players finding it difficult to evaluate the overall employment picture, hedge funds and investors with gobs of oil money are essentially being left alone to move markets.

     Right after U.S. payroll figures were announced, the dollar moved in the 118-120 yen range. The exchange rate is likely to remain volatile in the short term.

     Japanese stocks cannot ignore hedge funds, big oil investors and the desperate efforts they are making. French companies' trading of Nikkei Stock Average futures has been drawing attention of late. Traditionally, France has strong economic links with the Middle East. The Geneva branch of Swiss Bank, for example, was getting large-lot trading orders from Middle Eastern clients when I used to work there.

     Market players have started factoring in geopolitical risks, like the recent wave of terrorism. At this point, however, big oil investors seem to have an informational edge over hedge funds.

Itsuo Toshima is an independent investment adviser based in Tokyo and the former Japan representative of the World Gold Council.

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