Think you’d never be so stupid as to put your savings in a rip-off hedge fund? You may well have already done so

Despite the awful returns and rip-off fees of hedge funds, 4.8 million people in the UK are invested in them through their pension schemes

Hedge fund managers often take large, counterintuitive bets on the direction of markets – bets that ordinary fund managers don’t have the courage or the freedom to make (Getty)

“Um, hello – can I tell you about the real world?” Those were the words of a remarkably self-confident Scottish hedge fund manager, Hugh Hendry, on BBC’s Newsnight in 2010. He was addressing the Nobel laureate economist Joseph Stiglitz in a memorable debate about Greece.

The spicy and combative Hendry made for great television. He was invited back onto the show. Indeed, Hendry went on to appear on Question Time, where he airily cut off the then-deputy Scottish first minister, Nicola Sturgeon, with the words: “I know what I’m talking about, Nicola.”

The loquacious Hendry became something of a media personality for a period; the face of the UK hedge fund industry. But now, seven years on, the real world has told Hugh Hendry something.

Last week he announced the closure of his hedge fund Eclectica, after haemorrhaging investors’ money. It may have something to do with the fact that last year Hendry was apparently betting on a break-up of the entire European Union.

Hedge funds are investment pots, which claim to deliver superior returns to ordinary managed funds due to the intellectual brilliance of their managers. Often – and certainly in the case of Hendry’s fund – the strategy is to take large, counterintuitive bets on the direction of markets: bets that ordinary fund managers don’t have the courage or the freedom to make.

Sometimes these bets pay off and the rewards are spectacular. Often they don’t. And as a group, hedge funds have delivered miserable results in recent years, registering lower returns, on average, than funds that simply passively track the major stock markets. Not much evidence of brilliant minds there.

And those average returns for the sector have probably been upwardly biased by “survivorship bias”. This means closed-down funds like Hendry’s simply fall out of the various indexes of the hedge fund sector, flattering its overall recorded performance.

This matters. In 2016, more hedge funds closed than in any year since the financial crisis. Some 260 hedge funds were shut in the first quarter of 2017 alone – almost 3 per cent of the 10,000 total.

But running a failing hedge fund can still be very profitable for the fund managers themselves. Their traditional “two and 20” fee-charging formula (where they cream off 2 per cent of all assets under management every year, plus 20 per cent of any capital growth) means any investment success they achieve over an extended period ends up profiting the manager far more than the investor.

Of course, as we’ve seen, a great many funds never survive for an extended period. They simply shut up shop when they lose money after making a big bet that goes wrong. But 2 per cent of, say, a £50m seed investment is still £1m. Get a lucky run for only a few years, and a manager can accumulate an impressive fortune. No wonder hundreds of new funds open every year.

The media focus in relation to hedge funds tends to be on the potential risks they pose to financial stability. Could they blow up the system like banks did in 2008? That’s not entirely misplaced, given the size to which they could grow and the influence some of the larger ones can have on specific markets. Yet the greater risk from hedge funds is to the money of those who are naïve enough to invest in them.

So given the obviously poor returns of hedge funds, are investors yanking their money out of the sector en masse? Not exactly. Today there is around $3 trillion (£2.1) trillion of money worldwide invested in hedge funds – almost double the amount of seven years ago. Even when returns have been awful, the cash has continued to flow in.

Some of that money will belong to naïve rich people. But a large and increasing share, according to UK regulators, now comes from ordinary pension schemes, as their stewards seek to juice-up their overall results through an allocation of part of their money to “alternative” asset classes.

A report last year from SCM Direct estimated that 4.8 million people in the UK are invested in hedge funds through their pension schemes. The Tesco pension scheme has around £738m in hedge funds, while Lloyds Bank’s has a £1.9bn allocation. The West Midlands local authority pension scheme had £226m in such funds; West Yorkshire £259m. And so on. The vast majority of the ultimate beneficiaries of these schemes are likely to have no idea that they are exposed to hedge funds and their awful returns and rip-off fees.

A tiny number of hedge funds do deliver market-beating returns over a long period. But the vast majority don’t. Investing in them is, generally, a terrible idea. It’s an approach overwhelmingly likely to enrich the likes of Hendry and leave you personally worse off. But the folk who look after your retirement savings are doing it anyway.

That’s the “real world” of investment with other people’s money. And it’s certainly not the one Hugh Hendry was introducing us to seven years ago.