What Happened to the ‘Hedge’ in Hedge Fund?

If it sounds too good to be true--well, you know the rest.

Consider this e-mail message, which arrived last week, unsolicited, from a company calling itself Diamond International in Beverly Hills.

“Dear Friend: This is an EXTREMELY important announcement for you. Your Future May Depend On It!”

That should always get one’s attention.

The message goes on to invite me to learn from the “World Currency Cartel” how to profit from the “secret flaw” in currency markets. Discover the flaw, and you can convert $25 into “one hundred of legal currency,” the message assures. Not only that--I’ll be able to work this magic “from ANY CITY ON EARTH!!” (Those are their capital letters.)

Naturally, all I have to do is pay Diamond International an “administrative fee”--$45 by Oct. 10, $195 thereafter--and the instructions from the Cartel will be rushed my way. But please, don’t try e-mailing Diamond International back (they send e-mail, but they don’t accept it) or calling (no listed phone number).

It’s too bad that Long-Term Capital Management, the giant private investment fund that last week almost collapsed before Wall Street’s major brokerages cobbled together a $3.5-billion rescue plan, didn’t have the insight that the World Currency Cartel could apparently provide.

Turning $25 into one hundred (though one hundred of what, Diamond International didn’t say) looks like a far better return than the 40% annual gains Long-Term Capital earned in its heyday in 1995-96.

And given the Cartel’s knowledge of the “secret flaw” in currency markets, Long-Term Capital’s chief, John Meriwether, might have learned exactly how to hedge his so-called hedge fund’s bets in a period of extreme market volatility worldwide.

Instead, Meriwether took a few billion dollars of his own and his well-heeled partners’ capital, leveraged it up with $80 billion or more of borrowed funds, and engaged in a flurry of global bond market gambles that have since gone awry.

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Does it all come down to unbridled greed? That’s the easy call, of course: Meriwether didn’t know when to say when, and neither did his enablers, the Wall Street banks and brokerages who were only too eager to lend him money.

The spectacular growth of such hedge funds in recent years--whose invested capital (not including leverage) has ballooned to more than $120 billion now from $45 billion in 1995, according to New York-based Managed Account Reports Inc.--also speaks to the hunger of many institutional and wealthy individual investors to earn outsize returns.

It would seem that the savviest investors (hedge funds generally accept only people earning $250,000 or more a year) also would understand that high returns go hand in hand with high risk, and the potential for extraordinary losses.

But it has been reported that when Meriwether went back to his current investors for more money in recent weeks--to tide over the fund until markets stabilized--most balked. That forced Meriwether into the arms of his lenders.

Mark Strome, whose Strome/ Susskind hedge fund in Santa Monica has had plenty of ups and downs in recent years, says he had some of the same clients Meriwether had. Strome says he often heard those clients ask, “Why can’t you be more like them--they make money every month.”

What many hedge fund investors want, Strome says, is a non-volatile fund that consistently earns high rates of return.

If that sounds like a non sequitur--i.e., too good to be true--it is, for the most part.

Many hedge funds, like Meriwether’s, are set up to exploit market volatility. Because they can go both “long” (aggressively buy securities that they expect to rise) and “short” (bet heavily against securities that they believe are poised to plunge), one would think that the wild market swings of recent months would play right into hedge funds’ hands.

It hasn’t worked out that way. In August, only 12% of the hedge funds tracked by Managed Account Reports made money, according to Managing Editor Lois Peltz. “It’s disappointing,” Peltz concedes.

Still, many hedge funds have in fact produced tremendous returns in the 1990s. Of 16 categories of hedge funds tracked by Hennessee Hedge Fund Advisory in New York, 11 generated higher average annual returns than the average stock mutual fund from 1990 through 1997.

In a raging bull market, big money’s natural inclination is to try to get even bigger. Hence, wealthy folks’ cash has flocked to the hedge funds.

It’s only when the air goes out of the market bubble--as it has worldwide since summer--that big money, perhaps far more than small money, tries to run to safety. Capital preservation suddenly becomes a nobler idea than capital appreciation.

That phenomenon is what nearly sank Long-Term Capital, which apparently had made large bets that yields on U.S. Treasury securities would rise. Instead, they have plunged as investors have fled stock and bond markets worldwide for the perceived safety of Uncle Sam’s paper.

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Despite the outcry against Wall Street’s bailout of Meriwether’s fund, no government money is involved, although the Federal Reserve Bank of New York did help organize the deal. The Fed obviously felt there was too much risk involved in letting such a huge portfolio fail at a time when so many other disasters have befallen global markets.

Already, many in Congress are raising the possibility of bringing regulation to bear on hedge funds, which now operate with virtually no regulatory oversight.

But is regulation really needed? Hedge fund investors ought to know what they’ve gotten into. And if they don’t, in the vast majority of cases that’s their problem.

The only real lessons from Long-Term Capital’s debacle are a couple of old ones: No one is consistently smarter than the market, and high leverage vastly increases your chances of catastrophic failure.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.