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Published: 10 August 2007
Independent UK

For a while yesterday, it looked as if we might finally have reached the moment when the US sub-prime crisis would trigger a full-blown market collapse. As it was, investors across a range of asset classes and international markets endured a pretty bruising day, but European equities, for example, recovered some of their early losses.

One reason we have so far got away with a series of corrections rather than a real crash is the sub-prime affair has a leaky tap nature. Problems have dripped out slowly without ever becoming a torrent. That may change, however. The ever-increasing number of hedge funds caught up in the sub-prime fall-out may yet provoke that meltdown.

The hedge fund industry's fall from grace should not have been so unexpected, if only because it had become so widely venerated amongst investors tired of volatility on the equity and bond markets.

It's not difficult to understand why for a time so many institutions and individuals wanted hedge fund exposure. The sector's allure is its supposed ability to make positive returns whatever is happening on global markets. The potential for absolute returns, plus the lack of correlation between hedge funds and almost all other asset classes, is a powerful draw.

Indeed, the vogue for all things alternative began with the global bear market for equities of 2000 to 2003, a period during which many hedge funds produced spectacular results.

Given the punishment pension funds and other institutions took during that time, it's hardly surprising so many have subsequently embraced hedge funds with such enthusiasm. Over the past couple of years, many smaller investors have bought in too, generally through funds of hedge funds, which have sufficient purchasing power to satisfy the sector's very high minimum investment requirements.

The most high-profile of these fund of funds in recent times has been Bramdean Alternatives, the brainchild of one Nicola Horlick, no less. It raised a little over £130m last month, with the money due to be invested in a range of private equity and hedge fund assets.

Ms Horlick's pitch is that with thousands of hedge funds to choose from, investors need to be hugely discerning about which managers to back, or pay someone such as her to do the picking for them. The jury remains out on whether Superwoman is the right person for the job - until her fund produces a track record, that is - but the broader argument is absolutely sound. The truth about the hedge fund industry, surprise, surprise, is that as in every other area of investment, only a tiny number of managers consistently deliver returns, absolute or otherwise. And there are major flaws in the hedge fund model. In times of trouble, investors are locked in, yet managers earning performance-related fees supposed to encourage success are free to close down their funds if they're not earning a decent crust and start again somewhere else.

Much of the time, hedge fund past performance figures are unreliable and, at best, their investments, often leveraged, are opaque. This is why it's still not clear how funds hit by the sub-prime crisis have managed to produce such dramatic losses.

Last year's collapse of Amaranth should have been the wake-up call hedge fund investors needed. As it is, we may be about to learn the lesson much more painfully.