Why You'll Feel Hedge Funds' Pain

It is a perverse fact of life in the market for financial instruments that the well-intentioned quest for safety very often leads to the worst sort of dangers.

Almost 20 years ago, the great crash of 1987 came about in large part as a result of stock market participants' purchase of a kind of portfolio insurance that paradoxically caused the very type of volatility it was intended to prevent.

About seven years ago, the Long Term Capital Management hedge-fund crisis sprang from a wrongheaded theory by prize-winning economists that tons of money could be made with little risk by betting that the sovereign debt of various European countries would converge.

And now we learn that one or more major hedge funds may have suffered substantial losses this month -- and potentially ignited a "contagion" -- as a result of blown-up trades related to U.S. automakers in esoteric risk-avoidance instruments called collateralized debt obligations and credit-default swaps.

The trouble this time is unlikely to be as deeply pervasive as the first two, in which a passion for risk-aversion by well-capitalized institutional investors heaped billions of dollars of losses on the public. But because these instruments have never been stressed in a real-time crisis, it's hard to know exactly how they will act. We may discover that they could ultimately batter the public just as soundly.

Why should you care? It's tempting to view hedge funds harshly for any misjudgments they may have made. After all, in the popular imagination they are cowboys on the risk-taking fringe, only out for themselves.

Yet the reality is quite different. The hedge funds at the root of the problem may actually have been working on your behalf -- and at any rate they were tripped up by pretty conservative trades that went terribly wrong. The trouble that they encountered was the investment equivalent of getting hit by a truck while crossing the street at a well-marked intersection. Maybe you didn't look both ways, but the fact that you got crushed is more bad luck than bad karma.

The Emergence of Hedge Funds

To understand what happened, let's dial back and consider what hedge funds are and the background of their transactions.

From the time of their invention through the mid-1990s, hedge funds were primarily partnerships limited to investments by rich people that focused on profiting from both positive and negative moves in stocks, bonds, currencies and commodities. There are dozens of different types of specialist funds, but the purpose of most is to provide steadfast returns uncorrelated with the trend of the market on which they focus. The funds' members, or limited partners, pay managers up to a third of the profit for annually delivering the holy grail of investing: great results in good times or bad.