February 2008 | By Pablo Triana, Professor and Director of the Centre for Advanced Finance at IE Business School.

Although recent chaos in the markets brings back memories of past investment fads that ended in tears, this time itâ??s different. Hedge funds and derivatives have had some positive effects on finance markets and the economy.

Investors who seek fashionable products have been successfully persuaded over the last few years to invest in hedge funds and credit derivatives. Although the chaos that currently reigns in our markets reminds use of investment fads that went wrong in the past, this time there is a key difference, namely the fact that recently promoted strategies had a positive impact on financial markets and the economy in general.

In recent months, we have been bombarded by headlines like “Disappointing hedge fund returns”, “Hedge funds collapse”, “Problems with CDOs”, “Losses in CDOs”. If you allow me a certain amount of nostalgia, I feel myself transported back to 1989 (when I was a bit of a wild teenager) or 2000 (when I was a postgraduate student who wanted to continue being a bit of a wild teenager). In those days, as today, investments that appeared to be unquestionably “cool” suddenly became a source of misery. The must-have assets (junk bonds and dot-coms) became a death-trap for many of those who blindly obeyed the dictates of fashion. In their desperate attempt to become a member of the cool set, those investors paid a very high price.

Hedge funds and credit derivatives symbolise the trendy investments that were the (partial) disasters of our time. The modern, chic destination for your money. Unavoidable for those who did not want to be pointed out as old-fashioned and off-track. In recent years, the prevailing atmosphere seems to have been one of glorious exaltation of those with sufficient vision for transferring millions to increasingly complex financial structures and funds, together with the unlimited ridicule of those who, inexcusably, failed to jump on the train of new trends. Not very different from the days of junk bonds and dot-coms. In much the same way that a young woman is made to feel uncool if she does not buy her clothes in Zara or Prada, investors have been made to feel desperately off-track if they did not have positions in hedge funds and CDOs.

The most recent brilliant idea of the financial industry has been to convince the pension funds, portfolio manages, insurance companies, sovereign funds, university funds, private assets and even investors on the street that not investing in hedge funds and credit derivatives would mean that they would miss this train of popularity and abundance, showing themselves to be lacking the sufficient wisdom and courage required to take a unique opportunity. Not very cool at all.

Of course, implementing a highly successful marketing campaign sometimes brings poverty for both consumers and, paradoxically, the vendors themselves. Those who placed too much faith in the gospel of Michael Milken´s junk bonds or in the possibilities of selling petfood over the Internet were probably not very satisfied. And it could be argued that those who advertised the high-performance bonds and dot-coms paid for their overabundant enthusiasm (and capacity for conviction), since the insatiable demand that was generated led to a rapid deterioration of the quality of the offer, which undoubtedly brought about the eventual disaster.

Many of the investors who search for today´s trend probably feel that they also succumbed too easily and too intensively to the wily charms of the hedge funds and credit derivative dealers. A certain amount of rejection of these alternative investments is to be expected in the near future. Hedge funds and CDOs will no longer be so cool. However, unlike the junk bonds of the 1980s and the dot-coms of the 1990s, an indiscriminate bloodbath is not likely. Far from nearing their quasi-extinction, hedge funds and credit derivatives will remain as an established element of the financial landscape. Why? Simply because they are actually quite useful inventions that play a positive role overall.

If the junk bond bubble helped crazed buccaneers push companies to disaster and the Internet bubble helped useless “businesses” take elderly peopleâ??s savings, the latest investment trend has generated a more welcome legacy. By popularising hedge funds and credit derivatives, thereby making them more acceptable, the current situation has provided value. Both the very necessary market liquidity provided by the former and the possibilities of efficiently distributing the lending risks of the banks provided by the latter are extremely beneficial developments for the economy in general.

The recent years will be remembered as a time when the financial industry again enjoyed extraordinary success by mesmerising investors and pointing them towards cool assets, many of which inevitably failed. On this occasion, however, there is a difference: these particular products are in fact extremely useful inventions.

This article was published in the monthly IE academic newsletter IE Focus. To see the originally published article please click here.

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