No experienced, successful investor will be surprised at the suspicions that cling to hedge funds in the wake of repeated financial crises. When that much money floods into an investment area that fast, unpleasant financial events are bound to happen.

The huge investment attracts unscrupulous characters, and converts more than a few amoral individuals into thieves. The returns in Bernie Madoff’s hedge fund turned out to be pure fiction.

However, the bulk of hedge-fund losses will be in law-abiding funds that did what they said they would do, rigorously observed all applicable rules, and made sure nobody stole any money.

After all, the problem with hedge funds is that they make unfulfillable promises and pursue doomed investment strategies. That’s sure to backfire on investors, even when the insiders are honest, as they are in most cases.

Take the example of one notorious failure. Back in 1998, Long-Term Capital Management, a hedge fund firm built on the theories of two Nobel-Prize winning economists, lost over $6 billion due to the Russian financial crisis of 1998. A bailout had to be organized. While the firm was cited for tax avoidance, its trading strategy represented an essentially honest but misguided attempt to conquer the derivatives market. It ceased to exist in 2000.

Hedge fund operators and promoters claim that by combining an inherently conservative technique (buying stocks) with an inescapably speculative technique (selling short), you can somehow produce risk-free or at least low-risk profits. But the universe just isn’t constructed that way. If it was, why would anybody work?

How Successful Investors Get RICH Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor. How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Propositions that sound too good to be true

The lure of hedge funds has something in common with the lure of covered call writing, in which you combine conservative stock buying with speculative selling of call options. The fact that you own the stocks on which you are writing the calls doesn’t have any impact on the risk in the writing of the calls. Call writing and other options manoeuvres are inherently speculative.

However, most covered call writing takes place in individual accounts rather than funds. Losses tend to resemble a death of 1,000 cuts, rather than the out-of-nowhere mortal wounds that plague hedge funds. Most victims close their call-writing accounts before they go broke.

Something similar goes on in foreign exchange trading courses, for which you can pay thousands of dollars for a day or two of instruction. The theory here is that the liquidity of the foreign exchange market (or ‘forex’, as they refer to it in the ads) ensures that you’ll be able to get out of any one losing trade before the losses become overwhelming. True enough, of course. But a series of underwhelming losses, like the commissions you paid to acquire them, do tend to add up.

It all comes down to a rule that goes back to—well, to the Garden of Eden: When a deal sounds too good to be true, it probably isn’t true.

COMMENTS PLEASE—Share your investment knowledge and opinions with fellow TSINetwork.ca members

If there was one type of investment you would advise other investors to avoid, what would it be? Let us know what you think in the comments section below. Click here.

Why the promises of hedge funds are usually too good to be true. [Tweet this]