MARTIN WOLF

thinks investing in hedge funds will soon be as popular as buying sub prime debt. I agree many funds are on the chopping block. But I am not convinced the complete collapse of the hedge fund industry is inevitable or upon us.









bad

unscrupulous

Mr Wolf claims there are so manylucky hedge fund managers the industry has become a market for lemons. Investors will soon realise bad ones exist, but won't be able to spot them. They will internalise the potential downside from a bad manager and refuse to pay the high fees. Without the fees the good managers will leave the market for a better opportunity and only bad managers will remain. People will realise this and not want to invest in funds at all. Hedge funds are doomed for a collapse.









But the market for lemons assumes imperfect information. Information is publicly available, specifically a fund's performance. Mr Wolf points out that this may not really expose good from lucky managers. Lucky ones may have twenty years of good returns before things go badly. Twenty years of good returns sounds like more than luck to me. Even if it is, I would like to invest with someone so lucky.









Further, using the market for lemons used car example, many of people who invest in funds are the equivalent of a skilled auto mechanic. A large share of the hedge fund capital comes from institutional investors. They tend to be fairly sophisticated and can competently judge a fund's view. It is not perfect, but far from completely asymmetric information.









But if they are so savvy why do these knowledgeable investors bother with the fees and just invest for themselves? Large investors often have an incentive to keep hedge funds in their portfolio. Institutional rigidities may prevent the head of a large endowment from being too leveraged or taking too many short positions. Hedge funds provide these investors with the risk they would like, but can't take. This partly justifies the large fees.









Perhaps the industry has become too large. The current market turmoil will likely rid the market of many funds. But ultimately they are here to stay.