In the February 12th 2007 Ahead of The Tape column of The Wall Street Journal, reporter Justin Lahart also mentions the Dresdner Kleinwort research report by Stefan-Michael Staimann and Susanne Knips (covered by Toomre Capital Markets LLC ("TCM") here and here). The general thrust of this WSJ article is that it is becoming increasingly difficult for hedge funds to generate gross annual returns of 18% to 19% in order to deliver a 10% net return to deep-pocketed individuals and institutions.

The article mentions one common hedge fund strategy that appears to be low-risk, but could quickly turn dangerous if the financial markets were suddenly to turn. Many hedge funds employ various long/short strategies where they purchase relatively cheaper assets and sell relatively more expensive assets. Generally, the cheaper assets are less liquid because the market as a whole perceives them to have more risk of some sort. Some times it because it is of lower credit quality like a below investment-grade corporate debt. Other times it might be a mortgage-backed security that has an embedded option that generally adversely shifts the bond duration (relative a non-callable bond) as interest rates change. In both of these cases, higher rated bonds like treasury securities or interest rates swaps might be sold "short" to hedge most of the duration risk (decline in price due to an increase in yield). Other examples abound in other financial asset sectors such as equity markets, various types of energy investments, convertible bonds, asset-backed securities, and international government debt.

There is one issue, though, with this type of strategy. The various market sectors have a tendency to periodically shift sharply and quite abruptly. In times of stress, less liquid (and more risky) securities and derivative contracts become considerably less liquid and generally prices widen if there is any type of forced liquidation of the marginal (or leveraged) market participants. During such stressful periods, such long/short strategies tend to give back a considerable portion of their previous gains. Leverage during such periods tends to exacerbate such losses.

Do people recall what a financial market can be like when virtually everyone is a seller? Perhaps today's Wall Street wizards do not recall just how violent the 1987 stock market crash was, or the depth of the 1990 real-estate led credit crunch? Remember that there were fears in 1990 that once mighty Citibank might go under? Might not one keep in mind just how quickly bond prices plunged in early 1994 or the effects of 1998 Asian currency crisis and the relatively sudden demise of Long-Term Capital Management? Do today's hedge fund and proprietary desk traders consider what might happen if there is no liquidity? Do they understand that more illiquid spread products can have virtually no market price like what the credit derivatives sector briefly experienced in May 2005 with the down-grade of the auto makers to junk status?

This WSJ article also cites two other recent studies. "Brett Gallagher of Julius Baer Investment Management has shown that the difference in annual returns across stock sectors around the world has narrowed recently. James Bianco of Bianco Research has shown the same is true across world stock and bond markets. That suggests it is become harder to make money on hedge fund 'relative value' bets. " With emerging-market, high-yield debt, corporate-bond and mortgage-backed security prices having risen so much relative to Treasuries, it really is hard to envision them pushing higher yet still. As Mr. Bianco says, "If you're trying to impress on people that you deserve '2 and 20,' it's really hard to do in this environment."

What do you the reader think? How close are the financial markets to the "Great Unwind"? Is liquidity risk being properly considered? Your comments and thoughts are most welcome.