Stock Market Settles Down After Another Sharp Sell-Off

It was another stomach-churning day for many traders at the New York Stock Exchange as the Dow fell, rose and fell again to close at 12,234.34. (By Mario Tama -- Getty Images)

But many hedge funds and investors also are using the carry trade to make high-risk investments in the developing world. Emerging countries have never been so popular with U.S. investors, several investment groups report. And most of the best-performing mutual funds over the past few years were invested in emerging markets.

"It's not just the hedge funds and the leveraged players who . . . are involved" in the carry trade, said Kathy Lein, chief strategist of DailyFX.com, which provides information on currency markets. "A lot of regular people now are invested in the foreign markets."

Axel Merk, portfolio manager at the Merk Hard Currency Fund, said that in 2006, the market rose in a nearly straight line for eight months. "People became more courageous. . . . You say, 'Lets go for it, let's take a gamble.' Now, with more volatility, people are saying, 'Oops, wait a minute, I better be more careful.' "

Merk added that investors had to "become more cautious. That applies to the carry trade, that applies to equities, that applies to everything."

This week, as the carry trade showed indications of unwinding, money flowed in the opposite direction, from the emerging markets back to Japan. That pushed up the value of the yen. The first to sell investments in the developing world were speculators and hedge fund traders who can move their money quickly, analysts said.

Others decided to weather the storm and have seen their investments take a huge hit. "Every time there is a threat to the carry trade, we get a big, very quick reaction as speculators close out their trades," said Harvey Sawikin, co-founder of Firebird Funds, a $3 billion hedge fund mostly invested in emerging markets. "You could see a painful hit for a short period of time."

But Sawikin, who is invested in Russia and other places in Asia, decided not to move his money. He said many large emerging countries such as India and Brazil can absorb short-term blows from the stock market and are much healthier than they were in 1998, when a currency crisis roiled the developing world. But smaller economies in Asia, Africa and Latin America could suffer the most from the carry trade unraveling.

"There's indications that the emerging market has reached its peak and is going to fall off," said Howard, of Thacher Proffitt. "But it depends on which part of the emerging market you are referring to."

Tse reported from New York.