How safe are hedge funds as an asset class?

Last week Connecticut-based Amaranth Advisors, a multi-strategy fund that in August reported assets of more than $9 billion, met with major investors to discuss its predicament. For Amaranth had suffered a $6 billion loss in natural gas derivatives in August, more than $560 million in just one day.

Not surprisingly investors are looking at how to get their money back. But as an article on Reuters pointed out Amaranth had delivered strong performance in the past, delivering a $3 billion profit from January 2005 to August 2006, mainly through commodity trades.

Some industry commentators are now saying that investors ought to have read this success as a warning sign. So often what appears to be too good to be true in the investment world turns out to be just that.

Past performance

However, fund holders can hardly be blamed for seeing a good past performance as a guide to the future. That is how most investments are judged and what other guide is there?

Surely the deeper message here is about the way hedge funds are operated as an investment class. The basic business model is that you handover your money to somebody with enormous ability in financial markets who then conducts trades that no ordinary mortal could understand. You reward them with a share of your profits, and if they loose your money then too bad and they waive their 'profit share'.

The trouble with this system is not just that it is open to abuse as a largely unregulated sector where even the insiders are largely in the dark about precise trading systems. It is the very idea that by making large bets on market movements you will be consistently successful.

Unexpected events

The danger is always the so-called 'Black Swan Event', that rare and unexpected occurrence that wipes out a trader - and with it your money. This is systemic risk of a kind not always appreciated by hedge fund investors, especially at the retail end of the market.

There is a reason for the recent superior returns of hedge funds over mutual funds. It is in the ability of hedge funds to take leveraged bets, i.e. using borrowing to increase the amount of money in play. This magnifies returns in low-return but predictable markets, but also multiplies losses when things go wrong.

Indeed, a 'Black Swan Event' such as a sudden shift in energy prices is all that it takes to leave a hedge fund deep in the red.

That it could happen to Amaranth Advisors, a blue-chip in the sector is doubly worrying but it is a flaw in the business model of hedge funds that can allow this to happen. The high upside potential has an almost unlimited downside risk.