I found myself fuming, a few days ago, when I read about a city trader who had awarded himself a £28 million bonus after his hedge fund made £55 million by successfully predicting what would happen to the share prices of the largest UK banks.

As you probably know, hedge funds do not invest in shares or commodities themselves, but effectively ‘bet’ on them by taking out options to buy or sell at a fixed price on a set date at some time in the future. The buy (or ‘call’) option is used to force someone to sell to them at below the then current market price and the sell (or ‘put’) option is used to make someone buy from them at above the then current market price. Either way, they are in a position to make an immediate profit through ‘trading on’.

£28 million sounds a lot of money; but why should we bother? After all, nobody has lost out, have they?

Well actually while you could argue that the markets would have fallen (or risen) in any event – so the activities of the hedge fund have not actually influenced matters – losses have been made by the counter parties to the options, who unsuccessfully predicted the markets. More fool them, you might say, for getting it wrong.

But if these people are managing your retirement planning or your PEPs & ISAs then it is a matter of major concern to you. And insurance companies can use options within many funds, even with profit funds, although in that case it should be to reduce risk, rather than increase it.

Planning for the future is something that requires a degree of risk, or there is no potential for reward. However, what you do not necessarily want is the managers looking after your investments taking unacceptable risks with your money.

That is an individual issue. My concern was more general; do the hedge funds actually influence markets and therefore contribute towards the volatility of share values? Of course there has always been volatility, but with markets so dependent on sentiment and rumour, one cannot help wondering whether the very existence of funds dedicated to trading (almost by definition) contrary to the market actually causes greater swings than might otherwise happen. Making ‘bubbles’ larger and ‘bursts’ louder.

According to the investor, the banks have further to fall in value, as the need more capital; but that is one view, there may be others.

For investment advice, why not contact Robert Bruce Associates for assistance?