Behind the Fear In the Markets; The World economy is just right, but the markets are paranoid. I suspect the volatility is attributable to the sociology of hedge funds and their investors.

Byline: Barton Biggs (Biggs is a managing partner at Traxis Partners, a New York hedge fund.)

Why are the equity markets so paranoid? They're up one day, down the next, and I suspect that this volatility is attributable not so much to fundamental changes in the economic or business outlook as to hedge-fund sociology.

First, the recent history. At the end of October equity markets around the world began to rise. By late April things were getting a little crazy. The pros were putting money into exotic bonds and equities in places like Turkey, Russia and Brazil. Japanese retail investors, who hadn't bought stocks for a decade, subscribed for a billion dollars of a new India Fund. By May 9 risky assets had posted big gains, with small New Era tech stocks and the raunchiest bourses in the emerging markets showing the fattest returns.

The next day, out of a clear blue sky, markets from New York to Timbuktu plunged. The emerging markets index plummeted 24 percent, but much worse declines were not uncommon: the leading media company in Turkey fell 70 percent in dollar terms. By late June prices had stabilized, but since then markets have been manic-depressive.

Why? Sure, we have a new Fed chairman who has yet to be tested, and the Middle East is a mess again. But the world economy is still just right--not too hot and not too cold. Instead, much of the volatility is attributable to the rise of hedge funds and the sociology of their investor base. It is generally agreed that hedge funds, which control a tiny fraction of total stock-market investment, probably account for about 40 percent of the trading on the New York Stock Exchange and perhaps even more in the less formal markets.

Hedge funds use substantial leverage, on the order of two to five times their capital base. They are hyperactive traders, with turnover of 500 to 1,000 percent. This means that their purchases and sales in a year amount to five to 10 times their capital, so the amount of money they are moving is vastly larger than their stated size suggests. They also charge much higher fees than investment-management firms--2 percent of assets and 20 percent of profits--which makes their investor base very sensitive to performance.

Aggravating this tenderness is the fact that 35 percent or so of their ...