The term ‘hedge fund’ is a misnomer. It must be, or the number of hedge funds would not have halved in the past two years. If they had been ‘hedged’ against risk, those hedge funds which are now fully or partially closed would still be running other people’s money.

Hedge funds were promoted as the new asset class for institutional and large private investors. Yale University’s endowment funds invested in hedge funds which earned annual returns of over 20 per cent for more than a decade. Why buy equities when they earned less, were more volatile and could crash as in the dot com boom?

So investors piled in. And since institutional investors, in particular, tend to follow the herd, it became difficult not to invest in hedge funds. Such was the demand that traditional fund managers left the sinking ship of conventional equity fund management and started their own hedge funds. The rewards for them were much higher, not only a higher management fee – two per cent a year instead of, say, half a per cent – but also 20 per cent of the upside against a not very challenging benchmark such as the cash interest rate. And investors had to ask permission to get their money back again.

What happens to a hedge when there's a crash?
[image by The_repairman, some rights reserved]

Instead of sticking to borrowing a little and buying equities, many hedge funds chose to borrow a lot (interest rates were very low) and invest in bonds – often linked to the US subprime market. When this market collapsed, hedge funds were asked for more security to back their loans and had to sell equities to cover their commitments. Many have either folded or have refused to return money to shareholders, saying they will just have to wait until – or if – times get better.

It now seems so obvious it was madness to give large sums of money to a few people who said they could reinvent investment returns with no regulatory framework, no published accounts, and no transparency on fees and commissions paid. How could sophisticated banks invest their clients’ money in hedge funds such as that run by Madoff, which had improbably consistent performance figures? It helped that they earned good fees for so doing.

Hedge funds are now one of the main scapegoats for our credit crunch woes. European governments are planning to introduce regulation to stop fraud if not incompetence. But this is closing the stable door after the horse has bolted. When the markets turn up again, these fund managers will reinvent themselves – just watch for the next fashion in fund management!

About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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