What ever happened to noncorrelated assets? Modern portfolio theory suggests that investors should spread their funds among a wide variety of asset classes so that when one sector gets hit, another may prosper. That seems like a good idea until a selling wave engulfs pretty much all markets, as has been happening these past few days.

On Tuesday, stocks and bonds continued their plummet in the U.S., while European markets tumbled nearly 2% and Japan was off more than 4%. Weakness extended also to emerging markets, which hit six-month lows. All of which goes to suggest that the world’s equity markets may be more interrelated than at any previous time. Bond markets, which had been stronger in recent weeks, also suffered reversals, as inflation concerns led to the general expectation that interest rates would rise. We all know what’s happening to real estate.

Normally, such dismal news for stocks and bonds gladdens the hearts of gold bugs, as well as players in other commodities markets. But here, too, the news was grim. Gold prices suffered their biggest one-day drop in more than a decade on Tuesday, and crude oil was off more than 2%. So much for the diversified portfolio.

Why has there been such a convergence of results? We would argue that the uniform behavior of so many different segments of the market stems from the uniform source of incremental investment funds feeding into those many vehicles – namely, the hedge funds.

Different asset classes used to attract different types of investors, including real estate developers that inventoried land and industrial companies that hedged future commodities needs. Manufacturers bought lead for battery production or copper for wiring or timber for conversion into paper. Demand was determined by expectations of real usage; speculation about future price moves played a role, but was not the overriding factor. In the past several years, industrial buyers have been pushed aside by funds looking to find undervalued assets overlooked by their competitors.

Combined with an expanding economy and huge global liquidity, the hedge funds’ ever-widening search for new ideas has brought prosperity to almost every asset imaginable. Proof of this influence is the figures kept by commodities exchanges noting purchases for “commercial” use, which in all cases have receded as a percentage of the total. “Commercial buyers have fallen off the cliff,” a commodities analyst for Man Financial, Ed Meir, says. “There is no hedging going on. The funds have absolutely sidelined them.”

The problem emerges when a generally positive trend starts to buckle. Why? Because hedge funds are leveraged, causing them to be quicker to pull the trigger than other investor groups. Because they invest with borrowed funds, their impact is far greater than their $1 trillion under manage ment would suggest. Not only is the total of invested funds several times that amount, the turnover of the funds is substantially higher than for other investor pools. Typically, they move in and out of investments more rapidly than other market players. For all these reasons, the impact of hedge fund investors is much greater than suggested by the amount of money under management.

The skittishness of the hedge funds has undoubtedly been compounded by poor recent performance. In May, according to HedgeFund.net, results for the average U.S. manager were lower by 0.6%. Worldwide hedge funds were down 0.9%. Performance for the typical global fund of funds manager was worse: off 1.54%. Although year-to-date the sector is ahead of the market averages (up 6.29% in the U.S., 6.7% worldwide), the group is certainly not reporting the kind of gains that led to upward spiraling fees and dozens of newcomers opening up shop each month.

The race for performance is taxing, and has created days where the markets appear frenzied. Traders talk of the big players moving in and out of positions almost randomly, with little respect for the economic news that caused a move one way or another. For example, the current trigger is concern about inflation. However, the normal inflation hedges, such as gold, are being trashed along with everything else. A case could be made that rising interestrateswillhurt gold prices because the cost to carry gold positions will increase, but that argument in the past has been secondary to the view that owning gold was a hedge against inflation.

The manager of Balestra Capital Management, James Melcher, has run money for more than 25 years and says he is not at all surprised by the recent turn of events. “There are too many hedge funds with too much money chasing the same opportunities. I’m not worried about the 8,000 funds that are run by smart guys who know what they’re doing. I’m worried about the 400 or 500 funds that are new, inexperienced, and greedy. They’ve been pushing all these trades higher, because they know no fear. They’re like the race car drivers that are out in front because they’ve never been on the track before.”

When will the markets calm down? The CBOE Vix index, which measures expected future volatility, is finally moving sideways after a steep move up all week. Mr. Meir says he thinks the commodities markets will begin to recover once the volatility calms down. That expectation is based on the possibility that industrial users may begin to participate. After all, these consumers actually have to buy commodities, and they are price sensitive. “Copper prices are down 26% from a month ago; they’re going to like that” says Mr. Meir. One would hope.

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