Hedge Fund Shakeout Predicted

  In a must read paper, Professor Andrew W. Lo of the Sloan School of Management at MIT had predicted a hedge fund shakeout in the near future.  He found that when a hedge fund posts "smooth returns" that are too smooth to be realistic, it is a precursor to a hedge fund's reversal of fortune.  Looking across current hedge funds, he has noted an industry-wide "smoothing" of hedge fund returns, similar to the situation just before the 1998 global meltdown of hedge fund returns.  He speculates that hedge fund difficulties could create a "perfect storm."  Hedge funds, he notes are highly leveraged and vulnerable to having lenders cut off credit in a downturn, forcing the funds to close out positions at the bottom.  Multiple close outs would have ripple effects into the solvency of banks and brokerage firms that lend them money.  His solution?  A national crisis management team.  Seeing the crisis management skills of the government at work in the Katrina disaster should remind us that government crisis management is a slender reed.  I, as I have noted here, would force all lenders to tabulate and expose to public view their ongoing, open exposure to leveraged funds.