The hedge fund mania that is gripping the US and Europe is rapidly assuming all the characteristics of a classic bubble. It is not as big or as dangerous as the tech bubble but it could rattle some gilded cages in the financial world.
The bubble is all about the fallacy of composition, which states that individuals' actions are rational, or would be if others were not behaving the same way. It is when, after solid returns, investors last year rushed into private equity, oblivious to the fact that too much money would choke the goose that laid the golden eggs.
The compelling case for investing in hedge funds is well known. The belief that hedge funds can make money come rain or shine has not been tested in a bear market - but with an ugly market environment, the collapse of technology and private equity returns plummeting, hedge funds have become the new asset class of choice for the world's aggressive money.
Originally the domain of wealthy individuals, hedge funds are attracting money from foundations, endowments and pension funds. There is now more than $400 billion (€468 billion) of equity in about 6,000 hedge funds, completely unregulated and highly leveraged.
There are four principal participants: the hedge funds themselves; the funds of funds, which charge an additional fee for packaging; the investment banks that act as prime brokers; and the consultants who advise institutions and individuals.
Because there is a dearth of hard information about individual hedge funds, funds of funds and consultants can add a lot of value, not only in the selection process but also in allocating to different strategies and timing exits. However, they must be reasonably pure. There are numerous disclosure and conflict-of-interest issues in all these roles, particularly when one institution engages in three or four of them.
Although the great mass of the money is run from the US, Europe is going crazy too.
The mania is worrying because the money flow is accelerating. One estimate is that $4 billion of new money a month is going to hedge funds. Several corners of the industry show signs of severe overpopulation, which means returns are narrowing. Remember LongTerm Capital Management? Unfortunately, the successful hedge funds with records are mostly closed because their managers have become very rich and also know that their strategies are not scalable. Certain proved participants, instead of closing, have raised their take from 20 per cent to 50 per cent of the profits.
A lot of money is therefore going to the apprentices who worked for the old masters. A young person with a decent CV can raise $300 million and, if he hits in his first year, he will have $1 billion in a flash.
However, if the first couple of years are duds, the money evaporates. Some funds of funds and consultants say the old masters should be avoided because they are too big, too rich and probably investment-senile. Thus huge amounts of capital are going to the smaller, younger funds run by golden kids with itchy trigger fingers who for the first time have true portfolio responsibility. Leverage, inexperience and volatile markets make a dangerous cocktail.
Maybe I should not worry. Maybe they are all geniuses. What seriously bad things could happen in the public markets because of this hedge fund mania? I am not sure. As a child I was involved in the late 1960s and early 1970s hedge fund mania. No one wants to hear how that ended for the hedge funds or the big funds of funds of the time. Perhaps today's children are wiser in using leverage and less greedy. Hedge funds are important in initial public offerings and in many high-yield markets. Short selling and the derivative programmes that hedge funds use can swing the overall market.
I am sure that many new funds will explode and their investors will lose a lot of money - but that would cause barely a ripple. This is not a bubble such as technology, with a significant "wealth effect" that could affect the whole economy. But as investors, we should be aware of it.
The writer is a managing director of Morgan Stanley
