Christopher Swann

Prominent in most hedge fund literature are some impressive sounding figures. Since 1990, a weighted index of hedge funds has returned around 12 percent -- about 4 percent higher than the S&P 500 -- while offering half the volatility.

The figures testify not just to the superior performance of funds but suggests that most hedge fund managers "turn out to be relatively cautious," as James Simons of Renaissance Technologies recently claimed.

The industry should not be allowed to get away with such misleading claims. This should be the starting point of any new regulation of hedge funds.

The seductive figures so assiduously promoted by the industry exaggerate returns for several reasons. The easiest to correct is that reporting results is purely voluntary.

As research by Burton Malkiel of Princeton has shown, hedge funds tend to be quite happy to report results until they start to fail. In the six months before funds ceased giving data, funds produced an average monthly return of minus 0.56 percent, compared with an average positive return of 0.65 percent during their reporting lives.

Take this into account and aggregate hedge fund returns slide right back to the level of the S&P index.

Requiring funds to report results until their demise would help correct this -- providing investors with a more realistic estimate of the risks and returns of funds overall. By allowing a delay -- say three months -- regulators could eliminate the danger of compromising the investment secrets of hedge fund managers.

This is not to say that hedge funds - still off limits to the average investor -- should be as transparent as mutual funds; reporting to a regulator and to industry aggregators like Hedge Fund Research would be sufficient.

Regulators also need to address the backfill bias in fund figures. Managers should no longer be able to set up several incubator funds and then report only those that flourish. Not surprisingly, such backfilled funds produce the illusion of superior performance -- 500 basis points higher than contemporaneously reported figures.

Hedge fund investors may be wealthier and more sophisticated than the average investor. But they are still entitled to accurate numbers. The current selective drip feed of results from the hedge fund sector cannot be allowed to continue.

Hedge funds are the Rolexes of the investment world. Traditionally they have been available only to the wealthy. But as with any luxury product, imitators are never far behind. A range of funds claims to mimic the performance of hedge funds -- minus the princely fees.

Hero worship of hedge fund managers has meant that cut-price copy cats are often met with skepticism. However, hedge-fund replicators have now started to prove their worth.

A recent study by Swiss academic Nils Tuchschmid showed that 13 of 20 clone products did better than the average hedge fund during the financial crisis. All also outperformed the Standard & Poor's 500.

This should not come as such a surprise. A wealth of research suggests that many hedge funds now derive their returns as much from exposure to exotic risks and markets as to investment skill. MIT's Andrew Lo has concluded that talent accounts for as little as a third of hedge fund returns. The rest comes from market risk.

Overcrowding makes it harder for managers to stand out. When hedge funds were a cottage industry feasting on abundant market inefficiencies, generating alpha was easier. Now with an estimated 9,000 funds, dozens or hundreds of managers may be pursuing the same strategy -- cannibalizing each other's alpha.

The replicators still have just $2 billion under management and will need a much longer track record before they can silence the doubters. They may also struggle to ape some hedge fund strategies -- especially those investing in illiquid markets or demanding high leverage.

Even so, if their early promise is realized, the implications for the hedge fund industry could be profound. For the first time hedge fund-style strategies would become available to Joe Public -- reducing retail investors' almost total dependence on stocks.

Many traditional hedge fund clients may also be tempted to defect, lured by the low fees, full liquidity and robust regulation offered by the clones.

Truly talented managers have little to fear. But no investors should be paying a 20 percent performance fee and enduring lockups just for exposure to exotic markets.

For many financial services professionals the 2008 credit crisis was about as amusing as the Hundred Years' War. So it was refreshing to read "The Credit Crunch Diaries" - a humorous account just released by David Lascelles and Nick Carn.

This fictional tale of the meltdown is told in the parallel diaries of the chief executive and compliance officer of a major bank, Amalgamated Finance for Europe. The diaries chart the bank’s journey from reckless lending to government bailout and finally back to business as usual.

The tension between the pheasant-shooting patrician chief executive and the pedantic and earnest compliance office makes an excellent vehicle for comedy – slightly reminiscent the 1980s comedy “Yes Minister.”

Behind the laughs, lies a serious discussion about the failings of risk management at banks, the arrogance of bank executives and the moral hazard created by government bailouts. Compliance office Parquet is comically small minded, boasting in his diary: “It’s more than a year since I put up “WALK – DON’T RUN” notices in all the hallways and I’m pleased to report that the number of collisions between people and trolleys has been halved.” Meanwhile, Gershon is completely devoid of humility. “It’s not often that the jolly old Treasury gives you 10 billion with no expectation of getting it back,” he says. “Just relax. And enjoy it.”

The book ends on a discouraging note, with Gershon quipping that AFFE’s new motto should become “Too Big to Fail.”

Though lighthearted, the book is a powerful critique of the banking industry and government during the financial crisis. If you can stand the occasional rise in blood pressure, it's well worth a read.

Those looking for good news in the U.S. labor market are increasingly being forced to scrape the bottom of the statistical barrel.

Optimists pointed to the 34,000 increase in temporary workers in the otherwise bleak October employment report. Temp hiring has traditionally been seen as a sign that companies are dipping their toes in the water before creating full-fledged positions.

This looks like wishful thinking. A more plausible reading is that businesses remain skeptical about the recovery and will remain reluctant to commit to full time hires.

A lack of faith among companies could be self-fulfilling. Johnson & Johnson's recent decision to cull up to 7 percent of its workforce was justified -- in somewhat circular fashion -- by the impact of rising unemployment on consumer spending. Many other companies are likely to be making a similar calculation.

Even long into the recovery, businesses may still prefer to meet rising demand by using temporary workers. The number of workers stuck in part-time jobs has been rising relentlessly. In October, the unemployment gauge that includes involuntary part-time workers rose to 17.5 percent, from 12 percent last year.

Even as output starts to expand again, landing a job is getting ever harder. A year ago, almost a third of Americans losing their jobs managed to clamber back into employment in less than five weeks. Now just 20 percent are so lucky.

Instead, the average worker is languishing for more than six months without work. Businesses are still shedding jobs at a remarkable pace. The average jobs loss of the past three months of 188,000 -- while well below the lofty heights of winter 2008 -- is still close to the peak levels seen in recent recessions.

Individually, companies are right to be cautious. As government stimulus measures fade, consumers may lapse back into pessimism.

American households have barely made a dent in their record debts. Wage increases, meanwhile, remain stingy and credit harder to come by. But as the job slump continues there is a mounting danger that the pessimism of businesses and consumers will feed off each other.

It is becoming ever harder to justify the drip feed of government funding to GMAC.

The government has significant sunk costs in the lender after providing $12.5 billion to keep it alive. Just today GMAC sold $2.9 billion of FDIC-backed debt. Handing over up to another $5.6 billion would make little sense.

If the past six months have shown one thing, it is that GMAC's importance to the auto sector and the economy has been overstated. The company accounted for a vanishingly small 3 percent of auto financing in the first six months of 2009 -- half the level of a year ago.

The longer this decline goes on, the tougher it becomes for GMAC to argue that they are pivotal to the survival of the U.S. auto sector. Banks like JPMorgan and Wachovia have been filling the void.

True, the demise of GMAC would certainly be another nail in the coffin of General Motors, for whom it is still the default provider of finance. But there are far more efficient ways for the government to support the automaker.

In subsidizing GMAC Uncle Sam is backing a range of other activities that do nothing to bolster the economy.

The investment strategy of the group's banking arm looks suspiciously like that of a hedge fund. Low-cost funds from the Federal government have been used to scoop up a range of securities, swelling the bank's assets by 25 percent over the past quarter, according to Institutional Risk Analytics. It is difficult to see what the taxpayer gets from this.

Indeed GMAC may be undermining more viable banks, according to Christopher Whalen of Institutional Risk Analytics. GMAC's Ally Bank is offering generous above-market rates of interest on deposits -- a desperate strategy that leaches money from solvent institutions. (Were it not for the FDIC guarantee no sane saver would take such a risk.)

Such tactics have not stemmed losses at the finance group. Pouring more government money down this hole would be a mistake. At the very least the government should split up the group, allowing the non-auto finance components to sink or swim alone.

Better still, Washington should cut GMAC adrift completely and consider less wasteful ways of supporting GM sales.

In a world awash with government bonds, the Canadian variety is still as rare as black pearls. During 11 years of budget surpluses, the Canadians were in the unusual position of subtracting rather than adding to this supply.

Now the nation's recent descent into deficits offers a good opportunity for international investors to stock up on these gems. For years, foreigners have remained relatively immune to the allure of Canadian bonds. Royal Bank of Canada estimates that outsiders own not much more than 15 percent of marketable bonds -- against some 60 percent in New Zealand and a third for Britain.

Canada's 10-year issue offers the same yield as its U.S. counterpart. But Canada's bonds should be far more attractive than those of the colossus to its south.

Unlike the United States, Canada has not been forced to resort to unorthodox monetary policy. It is therefore at less risk of an inflationary accident over coming years than America, where huge volumes of liquidity will have to be mopped up.

This year's 15 percent appreciation of the Canadian dollar -- though painful to exporters -- will clamp down firmly on prices. Further rises in the Loonie remain a distinct possibility as global commodity prices continue to recover, and will offer an additional kicker to foreign investors.

Canadian bonds should continue to benefit from their scarcity value. After a decade of government thrift, the nation's debt still looks trivial by international standards. The federal debt to GDP ratio is set to rise to only 32 percent from around 29 percent -- less than half the Group of Seven average.

The government's claim that it can return to budget surpluses by 2013 is more plausible than promises of fiscal rectitude from other nations.

Over the past decade, those U.S. investors who bet on Canadian bonds yielded annualized returns of over 10 percent, including currency gains. This left the returns from U.S. bonds trailing in the dust, and also outpaced investments in New Zealand and Australia.

Another decade of outperformance looks like a sound bet.

China may deserve a round of applause for notching economic growth of 8.9 percent while most of its peers struggle with recession. Even next year, as other nations revive, China will still account for more than a third of global growth, according to Roubini Global Economics.

On reflection, however, this thumping growth rate is less of a boon for the rest of the world. Instead of being a driver of global growth, China will remain very much a passenger. Its contribution to the rest of the world will be based more on accounting than on reality.

Today's GDP figures provided further evidence that in its efforts to avoid a slowdown, China has been stoking over-capacity.

Even before the release, officials estimated that the peak output of steel was about 40 percent greater than expected demand. Purchases of cement, meanwhile, may absorb only two thirds of the industry's potential production.

Despite this looming glut, China's state banks continued until recently to shovel record funds into heavy industry -- more than $1 trillion in the first six months of the year. The consequences of this investment binge will last well into next year.

While the fiscal stimulus package wisely focused on infrastructure and consumer spending, this state-directed lending is setting up serious problems for China and the global economy.

The economy has become ever more tilted toward investment. Up to September, it contributed 7.3 percentage points to a growth rate of 7.7 percent. Fixed investment in urban areas was up by 33 percent in the first nine months of the year -- double the pace of retail sales growth.

Sliding producer prices, which plunged 7 percent over the year, suggest that over-capacity might already be starting to pose problems. As the investment tsunami generates ever greater output, China faces a series of threats.

Deflationary pressures could intensify, while employment growth slows and non-performing loans surge. Under these conditions, exporting will become an ever more important pressure valve for China -- precluding substantial progress in allowing the yuan to appreciate and further souring relations with the United States.

Besides, these capital intensive sectors are a poor source of job growth compared with the labor intensive service sector.

It is already too late to stop much of this. Moves to stem bank lending to heavy industry were necessary, but were applied long after the horse had bolted.

To prevent the problem from getting any worse, China urgently needs to remove the underlying incentives to over-investment in heavy industry. These sectors still benefit from access to subsidized energy, artificially cheap credit and bargain-price government land.

Withdrawing these perks will be politically vexed but is essential to creating more balanced growth in China, with stronger employment growth and more robust household consumption.

Robust Chinese growth will be a cause for celebration -- both in the nation itself and abroad -- only when it is more balanced.

Brazil's decision to impose capital controls has caused investors to howl. But a tax on foreign investment makes a good deal of sense for emerging nations seeking to stem inflows of hot money and slow a rising currency.

In the case of Brazil, action was needed. The nation has become a darling of international investors attracted by a combination of rising commodity prices, strong domestic consumption and sound macro policies. Overzealous traders were clearly becoming a liability.

The real is up by a third against the dollar so far this year -- making it the strongest major currency in the world. Overseas interest has also helped catapult the stock market up about 75 percent. Aside from the obvious danger to Brazil's exporters, enthusiasm from foreign investors is raising the risk of asset price bubbles.

On its own, the modest 2 percent tax on local bonds and stocks will not do much to calm the ardor of investors. A similar tax was in place in 2008 and did not prevent the real from reaching its highest level against the dollar of the decade.

Even so, the tax is a useful addition to the tool kit.

As a method for tempering currency appreciation, a tax on foreign investment has several advantages over buying dollars. Foreign exchange intervention can be costly for countries like Brazil. To avoid stoking inflation, intervention has to be offset by issuing domestic bonds.

For nations with high interest rates, this is a terrible deal. From its U.S. Treasuries, Brazil gets a tiny yield, with the three-month bill offering just 0.08 percent. Yet it has to issue bonds that pay out nearly 9 percent. A tax on foreign investments, by contrast, actually raises revenue.

For the same reason, such a tax may make sense for countries like India and South Korea that are paying dearly for their accumulation of dollar reserves. With foreign exchange reserves rising beyond a quarter of a trillion dollars each, the countries need to issue more bonds, and their costs quickly mount.

India has three-month securities that pay out 4.4 percent, while South Korea pays out 2.8 percent. A Brazil-style tax could at least help defray part of the expense.

For the United States, such taxes are the worst possible outcome. Foreign exchange intervention may hurt American exporters, but at least central bank purchases of U.S. Treasuries put downward pressure on their borrowing costs. By contrast an investment tax could end up damaging U.S. exporters and investors without helping U.S. Treasuries.

But assuming U.S. annoyance can be held in check, Brazil's strategy is extremely sensible and worthy of emulation.

America's inflation hawks have been circling. With bumper economic growth in the third quarter now being taken for granted, calls for monetary tightening are getting louder.

The producer prices data provide a salutary reminder of why this would be an awful idea. The risk of deflation may have abated but it has certainly not disappeared.

It is clear that companies are finding it increasingly difficult to raise prices. Core producer prices were up just 1.8 percent -- the slowest increase in two years, and about a third of the rate seen in the autumn of 2008. The cost of finished consumer goods has sunk more than 6 percent, with home electronics down 7.7 percent.

Prices can lag far behind other economic indicators, and it may be some time before the deflationary threat passes. Japan started to see falling prices only some three years after the recession started in 1991. Wages didn't start to fall until 1997.

The deeper a recession has been, the longer prices can remain under downward pressure long after an economy starts to recover. Given the severity of the current slump, it may be years before the United States is out of the woods. Even as growth picks up, capacity utilization remains at the lowest levels since government figures started in 1948.

Capital Economics, a consulting firm, believes that spare capacity is still around 6 percent of GDP, the largest shortfall since the 1930s. Closing this gap will take time. At a steady growth rate of 2.5 percent it will take until 2016 to bring America's resources back into full use. Even at a frenetic 5 percent growth rate it would still be 2012 before the output gap is closed.

The jobs deficit is particularly imposing. With around 1.3 million new workers entering the labor market each year, America may not return to its pre-recession unemployment level until 2017. And this is only if America returns to the growth rates achieved in the 1990s.

With so many people competing for jobs, it would not be surprising to see hourly wages falling for several years -- adding to deflationary pressures.

All of this suggests that tightening policy would be recklessly premature. Fed officials can afford to let the U.S. economy build up a good head of steam before following the lead of Australia in tightening policy. Strong growth alone is not a good reason to start removing stimulus and would risk strangling the recovery, as policy makers showed in 1937. As long as people and machines are idle, deflation -- not inflation -- should be the worry.

American consumers have shown a remarkable ability to defy economic gravity.

In September they again pulled off this financial conjuring trick. Underlying retail sales were brisk for a second consecutive month. It is impressive that American shoppers refuse to panic when confronted with high unemployment, stagnant wages and debt levels that would make European consumers swoon.

Yet this bravura performance will become ever harder to sustain into the winter.

To fully appreciate the strength of spending in the late summer, you need to strip out a series of volatile items.

The cash for clunkers program has sent sales whipsawing over recent months. Excluding autos, gasoline and building materials, sales climbed by 0.5 percent in September, building on a 0.7 percent gain in August. Beneath these aggregate figures are other indications that consumers are more willing to splurge on luxuries. Furniture sales were up 1.4 percent over the month, while clothing sales have now climbed in each of the past three months.

The deeply ingrained American habit of overspending is dying hard. But die it must.

A series of one-off boosts to income from government stimulus efforts are drawing to a close. Much of the money that seniors received from a one-off payout from Social Security may have already been spent. A tax credit for first time homebuyers is due to expire in less than two months. The cash for clunkers program, meanwhile, could end up weighing on consumer spending for some time as households digest the financial impact of buying a new car. All that is left of the consumer stimulus then will be the very modest reduction to withholding taxes -- about $33 a month for most workers.

As the government efforts fade, there is no sign that largesse from employers is picking up. Weekly pay for production workers has now fallen for nine consecutive months -- the longest contraction in the 44-year history of the statistical series. Even in the 1980s recession there was only a two month decline. Real disposable incomes have fallen in each of the last three months. Pay cuts -- once a rarity -- are becoming all too common.

In order to stump up the cash for recent purchases, Americans have been postponing the necessary task of repairing their personal finances. Families have levels of debt that remain stubbornly high and are still close to twice the peak of the 1980s boom. Yet consumers have returned to saving just 3 percent of disposable income. At such a snail's pace it will take roughly 9 years to bring household debt down to a more reasonable level of around 100 percent of disposable income.

Only a surge in wage growth in the coming months would enable consumers to keep spending at this pace. This is a long-shot at best.

Given this underlying weakness, the recent firmness of consumer spending is looking ever more like an Indian rope trick. Shoppers are likely to come back to earth with a bump this winter.