Hamish McRae: Are the horses a better bet than hedge funds? It's too early to tell

We are heading into a slowdown and slowdowns inevitably put pressure on the world's financial system. So where will this hit?

We are heading into a slowdown and slowdowns inevitably put pressure on the world's financial system. So where will this hit?

Like so many apparently simple questions, this one is fiendishly difficult to answer. There are an obvious macro-economic tensions - the current account imbalances and in particular the trade deficit between the US and China - but we know about those. They are, in Donald Rumsfeld's phrase, the "known unknowns".

Banks and other financial institutions will have put themselves in such a position that whatever happens, they will be secure. So a systemic breakdown in the financial markets triggered by something big like that is unlikely. Even a spike in the price of oil, now less likely with the downturn, could almost certainly be accommodated.

There are other tensions in Europe, which have increased as a result of the poor economic performance of the eurozone and in particular Italy and the Netherlands, both of which technically are now in recession. On a ten-year view there may well be some kind of wrenching change in Europe that would take the markets by surprise - a country leaving the eurozone for example - but that is not an immediate threat. Here in the UK there are worries about a collapse in the buy-to-let market, but while this may be tough for some investors, it is hard to imagine anything as bad as the early 1990s negative equity crisis.

Besides, it is not Rumsfeld's "known unknowns" that are likely to unseat the markets, but the "unknown unknowns". I had a discouraging conversation with a banker a couple of months back who pointed out that every period of very cheap money ended with some kind of financial crisis. Zero or negative real interest rates encourage bad lending decisions, and the world as a whole (although not so much the UK) has had a long period of these. In this banker's own institution, credit standards had dropped because of pressure to boost lending and he felt other banks had been even less responsible.

If, however, you ask anyone in the City where the crash will come, the answer at the top of the list will be hedge funds. Today the London-based Centre for Economics and Business Research predicted that 1,600 hedge funds would go bust over the next two years and cheerfully suggested people put their money on the horses instead.

Doug McWilliams, its director, reckons that after an awful March and April, the hedge fund sector world-wide has lost 8 per cent in value. Investors, who face poor returns elsewhere, will be dragged into riskier and riskier ventures just at the time when the investment opportunities of the hedge fund industry narrow. If a clutch of big funds collapse at the same time, he believes there is a risk of a run of collapses of financial institutions and of stock markets around the world.

Alarming, but is the alarm justified? The starting point is to be clear that hedge funds do not hedge. In fact they do exactly the opposite, for to hedge in normal usage is to reduce risk by laying off a bet. Hedge funds make bets. They are not regulated in the same way as conventional funds: legally more than half are offshore, with 54 per cent in the Caymans.

I am sure the Caymans are great for scuba diving but they are not known for depth of financial acumen. So the funds are located there to get around US and other national regulations. They can sell short, use derivatives, borrow money to gear up - all without normal disclosure requirements. This gives them the ability to dart in and out of markets with a freedom denied to their more lumbering cousins, but it also means there is less of a spotlight on their activities.

For people unfamiliar with the breed, the graphs, taken from a study by International Financial Services in London, sketch what has up to now been an extraordinary success story. Hedge funds hardly existed 20 years ago and now there are 8,000 of them, with net assets of nearly $1,000 bn (first graph). Most are in the US (or offshore US) but in the past couple of years growth has spread to Europe, with the UK accounting for three-quarters of the European total (next graph).

The investors have changed too. Invented as a haven for the assets of rich individuals, mostly Americans, the balance of funds flowing in has shifted to institutions, including pension funds (last graph). UK institutions have been more circumspect, or maybe less adventurous, than other European institutions, even though London dominates the management of the funds.

The people who run hedge funds are top of the range. They are very well paid, even by the standards of financial institutions, for the funds typically take an annual fee of 1-2 per cent of the money under management plus 20 per cent of the gain in value. No, they do not have to pay back 20 per cent of any loss. The justification for this is that returns have been very good, particularly when compared with conventional investments: on average returns of US funds were 16 per cent a year between 1988 and 2004, against an average return on mutual finds of 10 per cent.

But even clever people can only make money if the opportunities to do so exist. All markets have anomalies and when the hedge funds were a relatively tiny part of the market it is not so hard to spot and exploit these. Now they are huge; but the size of the marketplace has not risen proportionately, so you have a situation where more and more money is scurrying around and finding fewer and fewer homes to go to.

Now it may be that the funds and their investors are fully aware of the risks. Even if some of the world's richest people do lose some money over the next couple of years, they will probably have made enough in the past decade to remain well ahead.

A couple of bad years and the funds might gently subside, with the badly-run ones shutting and the well-run ones marking time for a bit. That would be fine. The investors are over 21 and know the risks. The worry is that some other factor - the interaction between hedge funds and the derivatives markets perhaps - intrudes. The markets are so new and the relationships between them so complicated that even the central banks don't know enough about them to be confident. You never know a system's weakness until it is stress-tested. Rising interest rates increase the stress.

Of course the central banks have huge experience of handing financial crises. What they do is pump in money. Simple really. There are costs in that it may just allow bad market practices to continue, but it is better than the alternative of a systemic failure.

Even if there is only a modest crisis by the standards of such matters, worries about financial instability will inhibit the ability of central banks, particularly the Federal Reserve, to increase rates. So maybe that will prove the real legacy of the hedge fund boom: even unregulated markets put a burden on the central banks, narrowing their options. And if this is right, then the long boom struggles on for a while longer yet.