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The Looming Threat That Could Initiate the Next Economic Collapse

Lurking behind the big banks is a mess of unregulated finance that could trigger the next financial blowup.

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So what’s the problem? Why shouldn’t ordinary small investors be able to get the same rates of return available to the wealthy?

Well, for starters, the gains are illusory. While some hedge funds have done very well for their clients, most fail to deliver on their promises of superior investment returns. Hedge funds typically take a fee of 2 percent of the sums they manage, plus 20 percent of profits. Once those high fees are taken into account, the funds underperform the market. Simon Lack’s book, The Hedge Fund Mirage, lays out the story in convincing detail, and shows that if all the money ever invested in hedge funds had been placed in safer Treasury bills instead, investors would have made twice as much money. Latest figures on hedge fund performance, such as those reported last month by Goldman Sachs, only confirm that these funds still consistently fail to beat the market, despite taking (in fact, because they take) fees many times greater than ordinary mutual funds.

Hedge fund investments inspire a more insidious, delusional effect: they allow state and municipalities to promise their employees certain benefits without allocating enough money to fund their commitments. The gap between promise and reality is huge: depending on which expert you believe, only somewhere between half and three-quarters of the necessary money to fund these pension promises has been set aside.

Politicians are caught between a rock and a hard place; either they raise taxes or renege on promises. By investing in funds that promise pie-in-the sky returns, those responsible for funding pension funds can continue to over promise and under deliver.

How is this going to work out? Not very well, if past performance is any guide. 

Pension funds would, over the long haul, be better off investing in more conventional investments, without taking on the additional risks of investing hedge funds. But following this advice would mean facing up to reality: there’s no such thing as an investment free lunch.

2. Money market funds are neither safe nor stable.

Late in August 2012, Mary Shapiro, the head of the Securities Exchange Commission announced the failure of her efforts to reform the $2.6 trillion money market mutual fund business. This is a rare example of Schapiro—who’s been a weak, ineffective regulator—trying to do the right thing.

Many ordinary people put money into money market mutual funds. These vehicles were created in 1971, and allow payment of higher rates on deposits than conventional bank deposits.. 

Unlike commercial banks, the companies that run these funds aren’t subject to regulations requiring them to hold extra capital in reserve, to make sure they can pay back people who’ve put money into their funds. Since banks have to satisfy these capital rules, and fund companies don’t, they get a competitive advantage. Funds are subject to laxer rules, because they invest in short-term government and corporate debt, which isn’t considered to be very risky.

The money market mutual fund industry has gone to great lengths to convince people that investments in their funds are as safe as bank deposits, and that you’ll always be able to get as much out of your money market mutual fund as you put into it. For accounting and tax purposes, the value of a share in such a fund was fixed at $1. This makes people think that an investment in a money market mutual fund is the same as a bank deposit.

Unfortunately, it's not.

John Bogle, the father of index fund investments and founder of the Vanguard Group, one of the largest mutual fund firms, recently identified money funds as “certainly one of the major risks in the mutual fund industry."