Secrets of Success: Hedging your bets may be a bad idea

For those who follow such things, a steady stream of stories in the past few days underlines how well-developed the coming bubble in hedge funds is threatening to become.

For those who follow such things, a steady stream of stories in the past few days underlines how well-developed the coming bubble in hedge funds is threatening to become. As with the dot.com bubble four years ago, and all the major market bubbles of the past, this one is unfolding before our very eyes - and, for the moment at least, nothing seems to be able to stop it inflating further. Here, taken virtually at random are just some of the telltale stories about hedge funds that I have noticed in the past few days.

1. The BT pension fund, the biggest in the country, says it is about to authorise investment in hedge funds for the first time, accelerating a growing trend for large investment institutions to branch out into this fashionable new asset class.

2. RAB Capital, a hedge fund business, has been brought to the stock market in a deal which originally valued it at £85m, in the process creating profits "on paper" of at least £25m for its two founders. This is the first of many IPOs City investment bankers are hoping to launch at investors in the coming months.

3. A hedge fund company is said to have offered the highest rental per square foot for office space ever seen in Berkeley Square, in the heart of Mayfair, the London hedge fund industry's homeland.

4. A former US hedge fund manager is being pursued across Europe by the FBI following disclosure that he abandoned the fund, leaving investors with heavy losses; one of an estimated 25 per cent of recently established funds that go out of business or close down each year (not always in such circumstances).

5. A specialist hedge fund publishing company set up by an enterprising journalist just a few years ago has been sold for more than $10m (£5.4m) to a large publishing group.

6. Schroders, the quoted fund management company, is said to be close to buying a 10 per cent stake in Thunder Bay Capital management, a specialist hedge fund firm, founded last year by Deutsche Asset Management's former chief investment officer.

7. The net flow of funds into the hedge fund business in 2003, according to HedgeFund.net, came to $72bn, bringing the total invested worldwide in hedge funds to roughly $750bn. The quarterly inflow in the last quarter of 2003 was not only the highest ever, but 50 per cent higher than the amount that flowed into hedge funds during the whole of 2002, the previous record year.

And so I could go on. Hedge funds, as if you hadn't heard already, are simply the newest and hottest thing in town. Every bank and fund management group you can think of either has plunged, or is about to plunge, into this business. Demand is soaring and, as always happens in such cases, supply is expanding to meet it as rapidly as investment bankers can make it happen. The Financial Services Authority (FSA) is meanwhile debating exactly how and on what basis hedge funds might safely be offered to ordinary private investors.

It is, I think, no accident that this sudden wave of enthusiasm for hedge funds is happening at a time when credit is about as dirt-cheap as it has ever been. Whatever you may think about the economic benefits of the cheap money policy being pursued by the Federal Reserve in the US, its consequences for asset prices can be seen all around you. Not least in the bumper profits being reported by the banks (who are effectively being given a licence to borrow short-term money at as little as 1 per cent and lend it on at 5 per cent or more - the easiest money they are ever likely to make).

It is precisely in this sort of climate that market bubbles are liable to be created. The hedge fund phenomenon is one such, just as assuredly as the housing market is brewing up to be another. In this sort of climate, it is easy to understand why the best fund managers are all leaving to either join a hedge fund, or to set up one of their own. The potential financial rewards are out of all proportion to what they could earn in their current jobs (which are hardly underpaid as it is).

There are good reasons, too, why banks and fund management firms are falling over each other to offer their own hedge funds to investors. The fees the firms can expect to charge (up to 2 per cent of assets under management, plus 20 per cent of any profits earned) are far more lucrative than anything they can expect to make on retail business, let alone the peanuts now paid for the commodity business of managing a company pension fund.

There is the added incentive that, if the value placed on hedge fund firms continues to rise at its current inflated rate, anyone working for a successful hedge fund can hope for a further huge windfall, in the form of a sale of the business at a ridiculously high price. RAB Capital is currently valued at four to five times the going rate for a conventional fund management business.

The fact that so many people now want to sell you a hedge fund is not, however, a good reason for buying one. Everything points to this being a serious bubble. There are simply not enough moneymaking opportunities around for all the hedge funds being planned and launched to be successful.

Managing a hedge fund requires a particular set of skills that is not as easy to acquire as the flood of hopefuls into the business want you to think (and may even believe themselves). Although different hedge funds pursue a widely varying range of strategies, most have an absolute return objective, which means seeking steady but positive returns in any kind of market conditions. They do this typically by making a large number of very small but profitable low-risk trades.

This was a good idea three years ago, when share prices were at their peak, but not such an obviously compelling consideration now. For the last few years, as the chart shows, in aggregate hedge funds have mostly achieved what they promised, positive real returns at relatively low risk. But the average figures conceal a wide range of actual strategies and outcomes, and the future will assuredly be different from the past.

But I have no doubt that the hedge fund fad will run and run for some time yet. Conditions could not be more helpful to the cause. But don't be fooled into thinking that a hedge fund is necessarily the answer to all your financial prayers. While some hedge fund managers are exceptionally talented, and deserve your money (if you can persuade them to take it), and they have some modest diversification value, rest assured that most hedge funds will fail to deliver anything exceptional.

With $750bn already invested in hedge funds, simple back-of-the-envelope calculations suggest that the fund managers and owners will take out a minimum of $7.5bn a year in fees, and in practice probably at least twice that much, in order ostensibly to deliver you a return that in aggregate, and on the most favourable assumptions, is unlikely to exceed 5-8 per cent per annum.

Risk aversion is all very well, but in five years I bet that we will all look back and wonder quite how so much money came to be taken in by funds that took so much out for themselves, and left so little in for those who rushed to buy in this year's accelerating stampede.

jd@intelligent-investor.co.uk