Hedge funds dangerous or boring

Hedge funds are rapidly becoming the Emperors New Clothes. Whilst the mythology and superstitions of the financial markets continues to believe that Hedge funds are the ‘best of the best’ figures show that funds are now extremely exposed and gains lower than ever. With the risk/reward ratios getting worse fewer funds are able to get off the ground.

The game was originally a rich mans game, where entry into the funds required in many cases a minimum of a few million dollars. The idea was to fund risky but lucrative opportunities and exploit areas the markets hadn’t noticed of hadn’t moved into yet.

But since the beginning of 2005 over 1,071 funds have been liquidated and less than half the numbers of funds have launched over the same period last year.

The funds have become so aggressive in their pursuit of gains that they have helped precipitate the collapse of many of the companies they originally set out to leverage gains off. Some governments and regulators have raised concerns that hedge funds, by their huge use of leverage in the form of CFDs and spreadbetting are effectively becoming ‘hidden’ majority shareholders by default – yet circumventing the usual regulatory responsibilities.

At the same time the returns from funds have moved from double-digit growth to an average return matching the market itself. More recently funds have ploughed into commoditisers, many banking on the continued growth of oil prices to generate high returns – with the collapse of oil prices from the all time high of $78 many of the funds have struggled with losses over the last few months.

With over 9,000 funds in operation, worth an estimated combined total of $1.2 Trillion there is worry that whole markets may now be vulnerable. At the same time many funds have leveraged higher off each other as a mechanism for spreading risk, however the gearing has increased exposure and created worries that if a few major funds fail, that the ‘domino effect’ may precipitate a crash of other funds. With the recent collapse in values of Vega Asset Management and Amaranth Advisors governments are looking to introduce stricter controls and focus on issues of compliance.

Perhaps the market is maturing and the general fall out over the current months is a result of market forces. But nevertheless, governments are right to be concerned about the gung ho! attitude of the market – as the funds are squeezed to make better returns and leverage increases – whole swathes of industry and markets will be vulnerable to fluctuations or chance.

Hedge funds will go the way of junk bonds eventually and effectively be absorbed into the day to day machinations of the financial markets. The days of ‘smart boys and fast cars’ are probably over as a more sober approach becomes the norm.