SPECIALS
Hedge Funds -- from Safety to Speculation

By Peter Temple
March 19, 2001

It's tempting to view hedge funds as the courtesans of capitalism: mysterious, exciting, and strictly reserved for those with plenty of money to put their way.

In fact they started off as safety-first investments. Not so much courtesans as the maiden aunts of investing. It's only recently that they have acquired a more raffish reputation. An American journalist called Alfred Jones set up the first one in the late 1940s. The idea was to earn returns from investing in stocks, irrespective of whether the market was rising or falling.

It did this by combining buying stocks that looked cheap with short selling of stocks that looked expensive. Short selling is selling a stock you don't own in the hope of profiting from a drop in its price. Would-be short sellers have to borrow the stock first from a compliant holder to perform this trick. Because the fund would profit if the "long" stocks went up or the "shorts" went down – it was insulated (or hedged), and not influenced much by the way the market moved overall.

Hence the term hedge fund. Returns were ratcheted up by borrowing and, for good measure, hedge funds have always charged their investors hefty performance related fees. Most hedge funds these days take around 25% of any gains, together with a 2% a year management fee.

Jones's funds did exceptionally well, and spawned a host of imitators, many of whom fell by the wayside in the bear market of the early 1970s – largely because they weren't true to the Jones ideal and merely speculated rather than hedged. Many of the most famous hedge fund operators – notably the likes of Geoge Soros, Julian Robertson and Michael Steinhardt – have since effectively retired from the scene, devoting themselves to charitable works.

One problem for hedge funds, and a major reason why these big players quit the game, is that if hedgies get too big, the market sees them coming and their secretive strategies don't work as well as they should.

Many hedge funds are small, however, and hedge fund styles vary considerably. The classic hedge fund simply does long and short stock picking, but others specialise in takeover stocks, buying up the debt of companies in distress, highly technical strategies involving bonds and so on.

Occasionally, the busts are spectacular or fraudulent. Long Term Capital Management – a bond-based hedge fund – blew up in spectacular fashion in 1998. At the time, it prompted fears of a global financial meltdown, only averted by prompt action by the US central bank and a consortium of creditor banks. Ostensibly LTCM's strategies should have been low risk, but the fund was leveraged 30:1 and exposed to more illiquid bonds that couldn't be sold in a hurry.

More recently there have been at least five cases in the space of less than a year of hedge funds collapsing due to fraud by the manager – more often than not revolving around falsification of performance figures. Investors in one fund got suspicious when they discovered that fund's address was a sandwich bar at a Los Angeles subway station.

The most worrying aspect of the hedge fund phenomenon concerns not the funds themselves, but banks that imitate them. Most large banks indulge in what is known euphemistically as "proprietary trading", shorthand for speculating on a grand scale with depositors' money.

The problem is that if bank traders are any good they tend to leave to set up their own hedge funds – simply because the rewards are better. Those that remain have bonuses linked to performance, which encourages the taking of excessive risk, while in many cases managers turn a blind eye or simply haven't a clue what's going on, until the losses emerge. Barings is the best example of what can happen, but there have been many other instances before and since.

Hedge funds have been hard to access for ordinary investors. Most demand high minimum investments. More recently, however, there has been a rash of fund offerings in the UK that have packaged hedge fund style investments to be within reach of the average ISA buyer.

The funds are marketed on the basis that they offer decent returns with low levels of risk, so much so that the UK's stock market regulator has been moved to warn investors only to invest if they understand what they're getting into.

Turbulent markets can be good for hedge funds, but risk-free they are not.

This article is adapted from Hedge Funds: The Courtesans of Capitalism, published by John Wiley, price £24.95.