Hedge bets and get rich safely

Universities should not lose their nerve after the near collapse of LCTM, says Andrew Murison

There has been much wailing and gnashing of teeth recently about the performance of a particular kind of stock market investment, so-called hedge funds, found in many an Ivy League portfolio - Harvard, Yale, Princeton to name a few.

One estimate suggests that 20 per cent of long-term funds at such universities are invested in hedge portfolios - which, with a minimum entry fee of up to $1million, are open only to the seriously rich. Some British universisites and colleges (not mine) may have invested in the offshore bond and hedge funds.

But the near-collapse of the United States-based Long Term Capital Management hedger has panicked many. Could universities end up slashing jobs and scholarship programmes because of risky investments?

The antics of LTCM raise fundamental questions. Are hedge funds responsible investors that deserve a place in every savings portfolio? Or are they uncontrollable speculators that habitually ruin their "investors" and wreak havoc on the world economy? And should universities trust their money to them?

Properly managed hedge funds are a good thing and universities should not lose their nerve. True hedge funds hedge their bets and perform well in any market. Latest figures for funds followed by this Cambridge college show that hedge funds' value dropped in August by only 0.23 per cent when the markets were down a whopping 15 per cent.

Because hedge funds are limited partnerships for the financially sophisticated, only the rich can invest. And being private and unregulated they are closed to public scrutiny. For tax reasons they are based offshore. Although behind this veil of privacy most hedge funds are productively hedging their bets, a few "big swinging dicks" (as they are known on the trading floor) are taking vast positions with no escape route.

LTCM thought it was a true hedge fund - "market neutral", meaning that it would make profits whichever way the market moved. But it was not. In a true hedge fund the manager takes a view on lots of different securities as to whether they are over- or under-valued. The more diversified the securities over different types of asset or countries, the safer the fund, because risk is spread over different economic circumstances. If the manager thinks a security is going up he buys, while simultaneously covering the position with an option to sell the security at (or near) today's price.

Because these options only cost about 10 per cent of the value of the holding, but cover the entire holding, the downside risk is covered at a cost of only 10 per cent while the upside remains unlimited. If the security rises by, say, 90 per cent the manager pockets a gain of 80 per cent. But if the judgement is wrong he only loses his 10 per cent, for as the price of the security falls the option to sell can be exercised. New shares are bought at the lower price and the securities underlying the option are sold at the old higher price. The profit offsets the loss.

With many bets on different securities producing a reasonable rate of high profit, and with losses automatically controlled through options, true hedge funds consistently make returns of 15 to 20 per cent per annum.

LTCM, however, did not diversify. It concentrated its bets in global markets on the single event of interest rate convergence between currencies. And this position was not hedged. Furthermore, it borrowed 100 times its capital to make these bets, so that a 1 per cent move the wrong way could wipe it out. When the "event risk" occurred - a flight away from the bonds of European currencies into dollars, so that their interest rates diverged rather than converged - the relatively small percentage losses were huge in absolute terms.

But why did 14 bankers rush to pump a mere $3.5 billion of new capital into LTCM - a drop in the ocean compared with the $100 billion of trading positions still outstanding? So that they could reap the rewards of the real decision that they were taking - to suspend the repayments of debt (in many cases to themselves) which otherwise they would have had to write off, threatening the financial system. Forced sales of $100 billion would have generated a spiral of further losses as a widening circle of banks called in loans.

Do not confuse the antics of these greedy bankers and reckless gamblers with the investment merits of true hedge funds. Hedge funds should come onshore, register with the regulators and illuminate their activities Then every university and every college should have some.

Andrew Murison is senior bursar at Peterhouse, Cambridge.