Hedge those bets

PLATFORM:MY FRIEND who works for a hedge fund is relentlessly optimistic, although his confidence has been shaken badly over the last few months. Nevertheless he is still at his desk looking for the right opportunities to make money because that's what his job entails.

Like Warren Buffett, who recently took over from Bill Gates as the richest man in the world, I'm not a big fan of hedge funds.

In the main, they exist to make wealthy people even wealthier, usually by using complex computer-generated financial models to exploit anomalies in the markets; although aggressively targeting particular sectors can also be part of the game plan.

Many funds have indeed made the wealthy wealthier; but others have imploded, some spectacularly.

The average person doesn't lose any sleep over a defunct hedge fund but the market itself dislikes failing funds intensely. This is partly because of the knock-on effect that off-loading the assets has on everybody else's portfolio but equally because many fund managers have an aura of invincibility about themor at least an aura of intellect.

If the biggest brains on Wall Street are getting it wrong, what hope have the rest of us?

When they can get it wrong they can get it spectacularly wrong. Hedge funds are relatively unregulated in comparison with other financial institutions and it is this, according to the aficionados, what gives the hedge the edge. The method by which the funds are supposed to avoid reckless trading is simply that the managers of the funds have their own money invested too. If the bubble bursts it bursts for everyone, including those with the towering intellects.

The most dramatic collapse is still that of long term capital management (LTCM) 10 years ago. LTCM had brains in large supply. It was founded by John Meriwether, former VP of Goldman's, and its board also included Myron Scholes and Robert Merton, who had shared the 1997 Nobel memorial prize for economics. When LTCM was good it was very, very good. When it was bad it was horrid.

Most hedge funds need to make about 20 per cent on an annual basis to cover their costs. The financial models need to be enormously efficient to do this.

LTCM's success in initially generating 40 per cent returns was partly responsible for its downfall. The more successful it was, the more it had to look outside its original strategy and the more it had to leverage up to exploit those market anomalies. It's the leveraging that can be so destructive when things go badly wrong. LTCM hadn't factored in the emerging markets crisis of 1998. In August alone that year it lost $2.1 billion. In September it lost $500 million in a single day.

People who don't like hedge funds fear that their excessive influence on markets, all done on the back of borrowed money, will one day lead to financial Armageddon.

Hedge fund managers themselves claim that their activities have actually reduced volatility because they immediately exploit mispricing in the market. Opponents suggest that as these anomalies become fewer, the hedge funds will have to take more and more risk to maintain their returns at the levels their investors expect. In other words, place bigger bets for the same return. And that ultimately this will lead to a systemic collapse in the market.

According to a recent paper, Leveraged Losses: Lessons from the Mortgage Market Meltdown, hedge funds are 3.25 times more leveraged than commercial banks. If you're borrowing big to make big bets, you need to be pretty sure of the ground you're standing on. Until now the hedge funds have had access to the cash they needed to keep the chips on the table. But how many of the tried and tested models, designed in times of easy money, have factored in the current inaccessibility of credit?

The problem is that, as the credit crunch continues, the funds' access to the cash flow they need is becoming more limited, just as the decline in the value of their assets (in some cases) is leading to regular margin calls. Selling assets in a declining market is not the way to generate wealth. Which means that the bets on making money regardless of market movements are beginning to look a bit more risky than they used to.

Last year Bear Stearns saw two of its hedge funds collapse. One was the high-grade structured credit strategies enhanced leverage fund. At least they got the leverage part of the name right! But the market shuddered as the fund folded.

Wealth creation is part of what makes our economy function but the emphasis that we place on the continued need for growth and return is sometimes overdone.

Wealth isn't the only bottom line. Creating it wisely is surely just as important.

Galaxy Popular Fiction Book of the Year Awards 2008

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