Should you sell-out of hedge funds?

So let us stay in the world of the general and not the particular. Many hedge funds are down 15-20% so far this year.

Now admittedly you are hard pushed to find a global asset class in positive territory in 2005: the US dollar and crude oil are the only two that spring to mind. Elsewhere, performance is dismal, and the hedge funds are only reflecting poor underlying returns in major asset classes.

However, like the highly borrowed funds that they so often are the tendency is to exaggerate the positive and also the negative. The bigger the bet that you place with borrowed money, the bigger the risk, and that is why hedge funds are not the place to be in a declining market!

There has always been something of a faint whiff of the unsavory about hedge funds. Large performance fees for managers, incredibly hard to understand investment strategies and offshore status. Any one of these factors might lead the cautious investor to stay away.

Yet the promise of a better return on your money than a bank account or equities has lured trillions of dollars into the hands of hedge funds. Most redemptions are only allowed on a quarterly basis, so it will be interesting to see how many hedge fund clients decide to cash in by June 30.

If too many decide that now is the time for a flight to safer, more conventional asset classes, then this will throw the entire industry into chaos. It will also cause mayhem in international financial markets where the hedge funds are the biggest players and biggest borrowers.

Predicting the impact of such unwinding of financial positions is even more complicated than trying to understand what on earth hedge funds were doing with your money in the first place. But clearly the clients will be the losers, and in heavily geared financial positions it is not uncommon to lose almost everything.

Will the central bankers be able to do something? That depends. Mr. Greenspan managed to cope, just about, with the collapse of Long Term Capital Management in 1998, but if the problem becomes systemic then he is in trouble, and so is everyone else.

Money would pour back into safe haven assets - such as gold, Swiss francs, and treasury bonds - and interest rates would have to plummet again, and the US dollar would plunge in value.

So sell out if you can before then, but did you note the catch in the small print? You will be locked in until June 30 and by then all the bad news could well be in the strike price. Let's hope it all proves to be one of those disaster scenarios that never happens!