During the last several weeks, world equity markets have coupled and, in general, have moved downwards. Although the magnitude of decline is well within the expected probability distribution of stock prices, nevertheless, some investors may become disconcerted because of a natural human tendency to extrapolate current events into an indefinite future.

One of the basic principles of investing is that the future return on a portfolio of risky assets is a random variable – i.e., not knowable. Over many long planning horizons, under some simplifying assumptions, actual portfolio return converges towards a number that is greater than the risk-free rate available through U.S. Treasuries or bank CDs. Likewise, over a single life’s long-term planning horizon, it is also reasonable to expect that a portfolio of risky assets will outperform a risk-free investment.

This expectation is due to the compensation owed to buyers of risky assets in return for their assumption of that risk. Financial economists call that compensation “equity risk premium.” If stocks did not go down periodically and unpredictably – did not, i.e., manifest downside risk – the long-term investor could not expect to receive a premium for assuming any risk. There is a vast literature on the topic of the equity risk premium; but, in a nutshell, stock price volatility is not an unwelcome characteristic of the investment landscape. After all, the only way to avoid investment risk would be to avoid all long-term projects; and in the final analysis, human society is entirely constituted of long term projects. The critical task is neither to avoid risk altogether – for this results in a long-term real return equal to the risk free rate – nor to maximize period-by-period portfolio returns – this quickly devolves into pure gambling – but to make sure that you’re comfortable with the parameters of the return distribution generated by your asset allocation elections. A long planning horizon offers “time diversification” (assuming independence of periodic returns); a well-designed portfolio offers “space diversification” (assuming low correlation of return vectors).

So, other than “re-setting” the expectation for attractive future equity risk premiums, what’s good about the current market decline? Perhaps the most salutary effect is the wringing out of leverage in world equity markets. This is the story of hedge funds; and, as you will see, the moral of the story is that you should have a big smile on your face because you were smart enough to recognize that the hedge fund industry’s sales pitch of a no-risk/high reward/ low correlation investment opportunity is bogus.

Hedge funds have become important participants in many global equity markets. Historically, most hedge funds have operated to mitigate volatility in the market place. They pursue strategies that look to buy “value” in some form (pairs trading is the obvious one, but other quant strategies like global alpha, long-short/market neutral, statistical arbitrage or even currency carry trades all operate under the same basic principle), and sell expensive securities to hedge. In the mid 1990s stock prices increased, in part, because of the enormous amount of liquidity that hedge funds brought to the market. Buying “value” is akin to a contrarian strategy (buy yesterday’s losers / sell yesterday’s winners) that makes money not only when markets for a security revert to their mean, but also by capturing for their investors some of the profits that historically went to dealers and market specialists.

As the hedge fund strategies became successful, more and more money has flowed to them. When more money is dedicated to a mean-reverting strategy, it improves the performance of the strategy. Whenever disequilibria crop up, people are quicker and quicker to arbitrage them away, with more and more money. As a result, overall market volatility steadily decreases over time and credit spreads continue to contract as more and more money appears to buoy those securities that dip and sell those securities that rise. Hedge funds made it easy for buyers to buy and for sellers to sell. Life is good for stock investors because market volatility is low, bid-ask spreads are low, and short sale ability keeps security prices close to their justified values. Life is good for hedge fund salesmen because they are collecting liquidity premiums for selling contrarian “insurance” to investors, because they are earning high rates of return, and because low market volatility seems to suggest that investors can have a free lunch – high returns without risk.

But, since returns from these strategies decline as more and more hedge funds arrive on the investment scene, increased leverage is necessary to maintain absolute returns. Initially, this aids the strategies by increasing the amount of ammunition the funds have. Everything seems fine. Until, of course, all of this money becomes insufficient to halt a directional move in some part of the market. Consider, for example, the recent sub prime / credit disaster. Leverage requires credit. If credit dries up in one segment of the market – e.g., housing – creditors may tighten the availability of credit to additional market sectors – consumer loans, stock margin loans, and so forth. Small drops in the value of the underlying loan collateral (stock prices) cause jitters in the boardrooms of creditors. The word goes out to hedge funds – sell some stocks to unwind the extensive amount of leverage in your portfolios.

But as soon as the first fund begins to sell its collateral, other creditors, in the face of additional stock price declines, force more hedge funds to unwind leverage. The vicious cycle begins. Despite good fundamentals, a large segment of the market then moves in one direction and does not stop. Financial economists call this market condition the “liquidity death spiral.” All of a sudden, the leverage players realize breathtaking losses. They are forced to cut back on their leverage and turn off their strategies. The immense flow of money that had dampened volatility suddenly dries up. Volatility skyrockets and pairs trading / “no risk” market-neutral strategies blow up. The multi year benevolent cycle immediately reverses to become a short term, very malevolent cycle as everyone rushes to the exits and all the stabilizing forces of yesteryear go into hiding.

When this process has finished, we will have come to the end of the market downturn. Hedge fund investors will have realized enormous losses, and will no doubt be pestered by fund salesmen trying to convince them that investment strategies that have succeeded will continue to perform well in the future, and that they should double down. Diversified (unleveraged) investors will continue to expect a risk premium; and – this is the good news – so much leverage will have been wrung out of the market that future expected risk premiums should increase. Thank you, hedge fund investors!