Sell-out: Why hedge funds will destroy the world

If hedge funds were a country, it would be the eighth-biggest on the planet. They can sink whole eco

Something ominous is going on in world finance - again. On 11 May, the US Federal Reserve, America's central bank, raised rates and hinted that it might do so again. Wall Street wobbled but stock markets in the emerging economies fell through the floor. Since that day, Colombia's stock market has slumped by 42 per cent; Turkey's by 38 per cent; Pakistan and Egypt by 28 per cent; India by 25 per cent; the Czech Republic by 22 per cent.

Why? These fast-developing economies have been the recent darlings of the world's mobile capital, acting as magnets for multinational corporations seeking new frontiers. Yes, the US economy is still the biggest in the world and changes in US interest rates affect the entire global financial system. But there is something very dark indeed at the heart of this story and it is called the hedge-fund industry - lords of havoc who, a consensus is building, have the potential to be responsible for the next great crash - and nobody knows what to do about it.

Howard Davies, then chairman of Britain's Financial Services Authority (FSA), admitted in 2000 that hedge funds were not very well understood by policy-makers and regulators, but then added: "That is not astonishing in one sense, in that if we do not regulate it, we need know less about it. But it is clear that if we are interested in systemic stability, we cannot ignore a sector which can mobilise around the same volume of assets as the US commercial banking sector."

When Dr Ben Bernanke, chairman of the US Federal Reserve, the most important financial supervisor of all, was quizzed by the US Senate banking committee about whether derivatives - complex financial instruments liberally used by hedge funds - should be regulated, he commented: "Derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and use them properly." This statement came pretty close to admitting that regulators don't have a clue what is going on and are therefore powerless to regulate the funds. Given their sheer size and increasing influence, this is stunning - and scary.

Hedge funds are private investment funds, primarily organised as limited partnerships - in essence, betting syndicates for the very rich. The amount of money they handle, in so far as anyone can estimate this, is mind-bogglingly large. The IMF's best estimate is $1trn; industry professionals reckon $1.5trn. If hedge funds were a country, it would be the eighth-largest in the world. To invest in one of these funds, you have to put in a minimum of $1m, although that initial investment is chicken feed compared with what can be earned - if that is the right verb for what amounts to global-scale gambling. The US Institutional Investor Magazine reckons that the top 25 hedge-fund managers in 2005 earned on average $251m each in 2004 - compared with $10m for the CEO of a typical top 500 US corporation.

Hedge funds are not new - just notorious. They started to take off properly in the late 1970s when floating exchange rates and volatile interest-rate movements transformed the capital markets, and gathered momentum as technology and electronic trading became increasingly quick and soph isticated. The funds were - and are - run typically by a tight group of traders, backed usually by fewer than a hundred individuals prepared to commit a great deal of money into their hands. Today, it is estimated that there are 9,000 funds and what started as a US phenomenon is spreading - though the FSA estimates that there are at present only 325 hedge funds based in the UK.

The key features of these funds are that they trade in eye-watering risk and they are barely regulated. The two are related. Because they answer to nobody but themselves, hedge funds have side-stepped regulation and can do as they like. What they like is risk - and their main tool is "leverage" - borrowing to play the markets. It is not unusual for a hedge-fund investor to control $100m in securities with only a $5m down payment. Of course, that means that when a bet goes wrong, it goes spectacularly wrong. If the hedge-fund industry's positions in the market are 20 times the cash they actually hold, their potential impact on the world financial system is about equal to US GDP.

That is why the emerging-market stock markets have taken such a battering over the past two months. Hedge funds poured money into emerging markets in the search for high returns, able to borrow billions relatively cheaply while interest rates were low. But as soon as the cost of borrowing increased they had to bail out rapidly, leaving the developing economies to clean up the mess.

Of course, recent losses were preceded by spectacular gains. India's stock market had doubled in two years, hailed by the country's leaders as proof that the Indian economy had taken off. For some, at least, it has - but the stock-market boom has greatly exaggerated India's progress. There have been huge inflows of equity investment from foreign investment banks and hedge funds and a large portion of that money came not from New York, London or Frankfurt, but from Mauritius, an Indian Ocean island that just happens to be a tax haven.

Yet no economy can possibly benefit in the long term from a tsunami of "hot money" crashing in and rolling out as fast as it had arrived. For a long time, India protected its economy with moderate capital controls, but its resistance to neoliberalism finally crumbled as it entered a frantic horse race to attract the increasing number of jobs offshored by developed economies. Now it has call-centres and IT development galore; but the quid pro quo has been a new and intense vulnerability to unstable financial flows.

Devil-may-care money

For the 35 per cent of India's population that the World Bank estimates lives on less than $1 a day, that is a gut-wrenching prospect. The long-term solution for any economy trying to develop in a sustainable way is to rely less on devil-may-care foreign money, institute a framework that encourages long-term investment, and look to its own growing numbers of affluent - some in the diaspora - to invest in their country's future. In the short term, the clamour is growing for hedge funds to be regulated.

Naturally, it is possible to argue that to the brave go the spoils. If hedge-fund investors are prepared to take the risk, why shouldn't they reap the rewards? If they live by risk, they should be allowed to die by it, too - in January the Eifuku Fund, based in Japan, lost $300m in a week.

This argument might hold water if hedge-fund gam- bling were purely a private matter. It isn't. When Enron, the huge US energy trading company that had increasingly relied on risky hedge-fund investing and leverage, collapsed in 2001, 4,500 people lost their jobs and more than $1bn of their pensions. Some $60bn was wiped off the value of US stock markets.

Enron's core business was failing - or had been hijacked by the greed and venality of its management. But hedge funds have the potential to wreck perfectly healthy and well-run companies. One senior British banker told me: "You talk to any FTSE-100 company and they live in fear of the hedge funds. If they choose to short your shares [a contract in which shares are borrowed for a set period on the bet that they will go down in price, and are then bought back, hopefully more cheaply, and repaid to the institution that lent them] you're fucked."

Hedge funds can arrest the development of whole econ omies, and they have the potential to crash the financial system. It has almost happened before. In 1998 the Fed persuaded the "Fourteen Families" (an apposite Mafia reference) of Wall Street - the major banks - to cough up money for a $3.6bn bailout for Long-Term Capital Management, a hedge fund whose bets went wrong. The Fed said at the time that LTCM's failure had been abrupt and disorderly and had posed "unacceptable risks to the American economy".

Nasty surprises

Has the lesson been learned? Of course not. Only a year after LTCM went under, the huge California Public Employees' Retirement System won the go-ahead from its board to invest up to $11bn - or a quarter - of the state pension fund's port folio in hedge funds. The FSA recently cited a J P Morgan survey which estimated that UK pension funds had allocated 4.8 per cent of their portfolios to hedge funds at the end of 2004, more than double the figure the previous year. Railpen, the UK railway pension fund, has invested £600m of its assets in a hedge-fund partnership, and Sainsbury's pension scheme has trebled its exposure to hedge funds.

So an increasing amount of ordinary people's money is available for use at the global gambling table. But how much could be at risk? We just don't know - and that means there is scope for any number of nasty surprises.

Even worse, as the regulators have admitted, they don't really understand this industry well enough to be able to deal with it. In June, the hedge-fund industry held a jolly at Knebworth, dubbed Hedgestock. Look at the titles of just two of the discussions: "'I can't believe it's not Beta' - Simple Beta, Complex Beta, Virgin Beta, and ABS factors - any Alpha left to spread around?"; and "'Incubator Alligator?' - sowing seeds, but do they stay for a cigarette?". One feels some sympathy for the Fed and the FSA.

In a world where, increasingly, we have only to twitch to be regulated it is pretty noteworthy that hedge funds are the exception. Either, in some way that we aren't clever enough to understand, they are of overwhelming importance to our collective well-being; or the regulators have in effect colluded with the wild frontiers of modern-day finance. They continually argue that hedge funds, by taking risks others won't, play a useful role in oiling the wheels of global markets.

Now, even they are alarmed that a hedge-fund-triggered meltdown is coming. Yet their efforts to move in on the hedge funds have been half-hearted at best, the habit of laissez- faire hard to shake off. Even when a serious regulatory effort has been attempted, it has been outmanoeuvred. In February America's Securities and Exchange Commission finally started requiring hedge-fund managers both within the United States and outside to register if they have more than 14 US-based investors and $30m or more in assets. In June the rule was thrown out by the US court of appeals for the District of Columbia circuit, on the grounds that it was "arbitrary" and didn't make a compelling case. Two senior Democratic senators are now trying to legislate to reverse that ruling.

Surely the Europeans, the last bastions against Anglo-Saxon free-market mania, will ride to the rescue. Well, not exactly. The EU internal market and services commissioner, Charlie McCreevy, recently ruled out new rules to regulate hedge funds, saying that they played a crucial role in putting the "fear of God" into company boards, to the benefit of all. A group set up to study hedge funds for the European Commission recently argued that the European industry was adequately regulated and needed to be protected from onerous new rules threatened from the United States.

So, hedge funds are increasingly looking to relocate from the US to Europe. It looks as if the wanton boys of the Dan gerous Sports Club will be allowed to carry on playing their virtual-reality money games - even closer to us poor sods trying to earn our livings.

Inside the hedge: a day in the life
by Al Fahunter

6.45am: I am in front of my multiple screens at our St James's-based offices after a Tube ride from north London, beating the rush hour and allowing me to read up on news and concentrate on the ordre du jour.

By 8am, when all European markets open, the phones stop ringing for about 45 minutes. This is when we decide what we'll do for the morning, trading-wise, until the US market opens or corporate and economic data feeds through. Today's story is that AMD is bidding for ATI in the US - great news if you hold European semiconductor stocks in Europe and Asia like me. The bad news is that Bank of Cyprus has pulled its counterbid for Emporiki Bank after a thumbs-down from Central Bank of Cyprus. I'd been building a position in Emporiki in the hope that Crédit Agricole would trump the Cypriots. I'm now looking at a €2 loss per share.

I concentrate on special situations in stocks and bonds - easily translated into M&A investments and corporate events, which have performed very well this year. I buy shares in the bid target and, depending on the bid structure, hedge my position by selling other shares or bonds - allowing me to leverage (ie, borrow) against the assets I manage. This usually inflates the bet two to three times the size of my investment, allowing me to reduce the risk and accentuate the gains.

My diary has calmed down for the summer, but the corporate reporting season is about to kick off: some companies are still vying for my votes or funds, so lunch is sushi at the desk while I catch up on the trading update. Like the 8am opening in Europe, the US opening at 2.30pm is followed by a period of tranquillity. Markets in Europe close at 4.30pm and we have the end-of-day auctions. I still have to attend a meeting and get a round-up from our traders. The gym beckons around 7pm; I have a quick drink with a broker at Just St James to catch up on gossip. Having missed Arki Busson's charity evening, which raised £18m in one night in June (it clashed with World Cup trips to Germany), I was dying to know who bid for the yoga session with Sting. If only I hadn't had to listen to the glowing praise for Arsenal's new stadium from one of my Arsenal-supporting brokers who attended the Dennis Bergkamp testimonial last Saturday, I could have called it a good day.

Al Fahunter is a pseudonym

Hedge funds by numbers

$1.5trn Total amount of money managed by hedge funds worldwide

9,000 Estimated number of hedge funds today

$250bn Estimated value of the Asian hedge-fund industry by 2010

$750,000 Amount that GLG Partners was fined for alleged insider trading by its star hedge-fund manager, Philippe Jabre

Research by Daniel Trilling

This article first appeared in the 31 July 2006 issue of the New Statesman, Sell-out: Why hedge funds will destroy the world