The explosion in the number of Hedge Funds over the last decade is indicative of the desire by many, often very rich, investors to beat what might be called normal market returns.

Prior to the late Nineteen Fifties, in particular, before Harry Markowitz’ seminal work on Portfolio Selection, investing in shares was considered to be a risky and unquantifiable business, one of the main reasons why dividends then were usually higher than the return on Government Bonds.

Once it became possible to apply a bit of ‘science’ to risk and return and, in particular, the benefits of diversification became better understood, the stock markets became a more comfortable place for more investors.  Unfortunately, with the banning of insider dealing, improvements in corporate governance and the wider availability of high quality information, much of the mystique disappeared taking with it the prospect of excess returns.

This leant a huge helping hand to Hedge Funds who were able to market themselves on the basis of excess returns created by clever (at least in theory) financial models and leveraging.  The great advantage of leveraging is that if you expect a return of 10% and borrow ten times your original capital, that turns into a 100% return, very nice.  However, if you lose money with borrowings, you may find out that all of your capital is lost and you owe the bank money, not so nice.

Also, those running hedge funds were, in many cases, the cream of the financial world, particularly on the academic side.  Hedge funds gave plenty of scope to the highly intelligent to make money on the back of academic work.  In some cases, this level of applied IQ has been their downfall.  In physics, classical mechanics works very well in many practical applications and was good enough to land a rocket on the moon safely.  It breaks down completely at the margins, however.  In much the same way, many seemingly low risk ways of making a ton of money which were created by these boffins seem to break down spectacularly when faced with real world problems, particularly lack of liquidity.

So it is that Peleton, until last week a highly regarded British hedge fund, has found its strategies wanting.  In the process, it may be that investors will lose much if not all of their money in at least one of its funds.

You have to hand it to the old fashioned technique of buying a range of investments and sticking with it.  They may have dropped in value periodically but there was always the hope (born out in fact) that prices would recover with patience.

It may be that, for many, hedge funds will permanently have lost their lustre, as will any strategy promising to deliver excess returns for lower risk.  That is until the lessons of today have been forgotten, as they almost always are.