Jeremy Warner's Outlook: The herd, the hedge fund and the billion dollar rip-off. How we all got mugged

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The Independent Online

One of the curiosities of markets which financial crises repeatedly highlight is the tendency of investors and money managers to go charging after the herd into the latest glamour sector or product even though they know it will eventually end in huge losses.

Herd-like behaviour among investors is not simply explained by stupidity. Most asset bubbles are fairly obvious phenomena, even while they are still inflating, yet despite the fact that everyone knows they must eventually deflate, they remain strangely seductive.

Nor is this apparent willingness irrationally to ignore the dangers explained entirely by greed: you know it's a bubble, you know it will eventually end, but hey, prices could double again before gravity takes hold.

Rather it is the tendency of rules, regulations, peer group pressure and received wisdoms to reinforce bubbles that interests me. We saw it in the dotcom bubble, the credit boom of recent years and now all over again in commodity prices, which are being driven to what everyone instinctively knows are unsustainably high levels. How do apparently sane investors and money managers allow themselves to get drawn in? The madness of the dotcom bubble is a good example of how it works. The standard explanation for the great "dot.con" is that investors were seduced or conned by avaricious investment bankers into paying crazy valuations for essentially worthless enterprises.

Yet many invested against their better judgement not because they were persuaded but because they believed they had to. This was partly because everyone else was doing it, and you risked being left behind if you didn't. But actually it was worse than that. Many money managers are set up on the basis of rules that require proportionate investment in different asset classes.

The new asset classes of choice in recent years have been private equity and hedge funds. There would also have been "forced" investment into Collateralised Debt Obligations, and all the other complex securities that lie at the heart of the present mischief.

If as a bank or fund manager you didn't invest in these assets, with their apparently superior returns, then someone on high who in all likelihood wouldn't understand the first thing about them, would want to know why.

Hedge funds have been some of the primary beneficiaries of these self-reinforcing investment trends. The term "hedge fund" covers a multitude of sins but there are common characteristics, chief among which is that hedge funds are a device for allowing financiers to pay themselves hugely more than was ever possible in traditional investment management of the type that saw your money invested for the long term in plain vanilla stocks, shares, property and government bonds.

By way of generalisation, it works much like this. The hedge fund manager sets up a system for borrowing in the wholesale markets wherever he can find the cheapest rates, and then lending it on a bit more expensively – in other words, a simple interest rate arbitrage.

This margin is likely to be quite small, yet by gearing the returns up through debt leverage, the manager can magnify them to levels where they appear to outperform almost everything else. It's hardly rocket science, yet it is sold as such by money managers who paint themselves as financial wizards and innovators of extraordinary cleverness and ability. In fact, they are no more than snake oil salesmen.

Yet here's the really clever part. In return for managing your money they charge you a standard old-style fee of perhaps 2 per cent, or enough to pay costs and a good salary. But because they are so brilliant at generating superior returns, they are also going to take 20 per cent of the upside. This is passively agreed to by the investor because the returns are so fabulous.

With all interest rate arbitrage, eventually the unforeseen will happen and the positive margin will become a negative one. The gearing then goes into reverse and, as has happened with a number of hedge funds over the past nine months, the investor loses everything. The banks which have provided the gearing will also be severely hit.

But the manager, who in the years of plenty has religiously banked his 20 per cent of the upside – that's if he can find a safe bank – will be living in Switzerland and jets off to Barbados at the weekends in his own private jet. If the consequences of this mass heist on the general public were not so serious, it would be almost funny.

Unfortunately for you and me, some wretched trustee or rule-setter somewhere will have decreed that, because hedge funds are such a spectacularly high-performing new asset class, part of your pension must be invested in them even though common sense would tell you it's a con. Hey-ho.