The financial system is still struggling to cope with the mayhem created by toxic assets and the outpourings of crazy credit which caused banks to fail and forced governments to prop up financial institutions with hundreds of billions of emergency funding they can ill afford. Interest rates are virtually rock bottom. Loans are virtually free to borrowers. However, few corporates are prepared to take on new debt, while most investors are ready to save money in banks when they can earn no returns.
In such a climate, it is therefore all the more remarkable that the world’s hedge funds have just enjoyed their best ever three-month period in terms of funds inflow. No less than $143 billion has poured into them between April and June this year. In the boom times, these funds often outperformed the stock markets, in part because their use of futures and options allowed them to buy the right to both upside and downside of a risk and only exercise the profitable “hedge.” Of course it was not quite that simple and had such a strategy been as foolproof as it seems, large numbers of hedge funds would not also have lost heavily in the financial crash.
Nor are hedge funds obviously that attractive for the extremely rich individuals or investment managers that place money with them. For a start the investment generally has to stay with the hedge fund for a fixed number of years.
There is no opportunity to bail out in a falling market. Then the hedge fund managers charge a fee for managing the often substantial sums placed in their care and finally, a hedge fund will also take a proportion of the profits it generates with investors’ money. In the case of one-star hedge fund manager, this share was at one stage fully 40 percent of the return. Such fees and profit sharing of course exist in the mutual fund industry worldwide but the figures are never so dramatic to make multi-billionaires out of the handful of partners at some of the most successful hedge funds.
So why is it that so much money is cascading into these investment vehicles? Some analysts argue it is the lack of decent medium-term returns in most other markets. But then the hedge funds will be investing in those self-same markets. The only apparent edge they have is their supposed ability to cover their investment risks, whichever way the markets move. But this they do at a price and on terms, which make them seem an expensive way of investing.
Is this perhaps rather the return of “irrational exuberance” by investors who have chosen to believe that in a generally depressed economic environment, there are a few wealthy and therefore by definition, extremely wise individuals who know how to defy market realities? At the heart of this, as of all past booms and busts lies the refusal of investors to question the truth of widely held economic fashions and to examine what it is that they are really buying and at what real potential cost.
