Out-of-date instruments carry valuable principle

One of the longer-established fund-management firms in Hong Kong has the walls of its conference room adorned with old railway bonds from around the turn of the century.

When you are escorted inside, waiting the requisite five minutes for the person you are seeing to show up, you have a chance to look at them closely, and it quickly strikes you how unusual these instruments were.

Here you had a London merchant bank, the original parent of the fund-management firm, raising money for new railway ventures, businesses that even then had long been highly speculative, in Argentina or China, countries which it is unlikely that anyone from the bank ever visited.

Yet the bond note tells the prospective purchaser that he may collect one guinea, let us say, from the merchant bank every year by clipping off the coupons and bringing them to the bank's offices and that in 70 years' time he can redeem the entire principal.

Did the people who issued this bond or the people who bought it ever think of inflation or currency risk? Where today could you find anyone issuing a highly illiquid 70-year fixed-income instrument for a risky venture with revenues entirely in a foreign currency and offer only an ordinary market yield to compensate for all of this? It wouldn't happen. These risks are apparent to us now and investment specialists no longer do such silly things.

But it did not necessarily seem silly at the time, which introduces the question of whether we may be doing things that people will see the evidence of on conference room walls 80 years from now and shake their heads in amazement.

Hedge funds don't hedge. It is a useful word to employ when appealing to the public for money but, if the intention is to make more money than anyone else can make, why limit those winnings by taking contrary positions on the markets? One appeal many of them have used goes something like this: 'If we make money, sir, we will keep 20 per cent of the winning for ourselves, and if we don't make money we will charge you nothing, so, as you see, you participate on the way up and on the way down we work for you for free'.

If the number of people who find this convincing is any guide, then fools are not born every minute but every split second. The hedge fund manager wins big for himself with your money on the way up and on the way down he loses a few cents on management but you lose your fortune.

His game is heads-I-win-tails-you-lose, and of course he is going to flip that coin as quickly and as often as he can until his thumb wears out. He has been given an enormous incentive to take the riskiest bets on the market.

He has another appeal to the public which also works wonders. Remember that the fund-management game is not so much about managing money as about getting more money to manage. This appeal is to wonders of the computer.

There won't be any decrepit human brains at work on your investment. Some bright spark at Harvard has come up with an unbeatable piece of software and it will be used entirely for you, sir.

And then it all falls to pieces, as it did on Thursday in New York, when regulators and banks scrambled to cover the imminent collapse of a big hedge fund.

Did these people truly think that they could introduce all sorts of volatile instruments to enliven markets and the markets would not themselves become more volatile? Did they truly think that the exits they built into their software in case things should go wrong would never have to accommodate a stampede? Apparently that's what they thought. Silly isn't it? But silly as they may have been in the 1890s, they were not so silly then as to make others pay the price of silly speculations.

Others stood aside when the merchant bank, whose offshoot has the railway bonds in its conference room, wiped itself out on Argentina.

It will be a sad thing if that lesson of the past is forgotten today.