In a Financial Times online article dated June 2nd, Mr. David Smith – the Chief Investment Director of GAM (part of the Swiss wealth management company Julius Baer) discusses the hedge fund bubble burst of 2008. As part of his analysis he says:
The research group Gartner tried to prove the potentially positive outcomes of bubbles in its theory of the “hype cycle”, in which mass adoption of any product begins with a “technology trigger” that generates significant interest. This leads to a “peak of inflated expectations”. When reality fails to live up to these hopes, the industry enters a “trough of disillusionment” in which many businesses leave. Those that remain continue through to a “slope of enlightenment” in which a more practical understanding of the technology’s potential is reached. The final stage is the “plateau of productivity”.
One key factor missing from Gartner’s analysis is capital. The surge to the “peak of inflated expectations” can only occur if capital is cheap and freely available. And this is a key point to remember when analysing the hedge fund bubble of 2008.
The Gartner Hype Cycle was created to analyse technology innovations progress through their markets from an adopters point of view. While we are always very happy to see its use extended to other fields, it is not a general economic theory about bubbles and we would not wish to give that impression. We are not economists.
Mr. Smith makes a good point about the availability of capital. While the hype cycle will be in play for even the simplest and cheapest of innovations, its magnitude can certainly be amplified considerably by freely available capital. The dot com bubble is the most obvious example. The Silicon Valley funding of web 2.0 is another.
Hedge funds are not a new invention; they have been around since the early 1950s. Forbes Invstopedia suggests there was a hedge fund boom peak in 1968, followed by a crash in 73-4, then another boom in the 90′s which saw a major fallout in the early 2000s. So we have just passed through a third wave. It therefore seems likely hedge funds form a repeated cyclical, or boom-bust investment market, like property, that rises and falls repeatedly. Over the medium term (perhaps 5 to 10 years) this can sometimes be mistaken for a hype cycle. We have noted the difference before in this Blog. In the Hype Cycle two underlying curves create the shape: the social excitement bell curve plus the innovation performance maturity S curve. It is not obvious that hedge funds in their current form are a new invention, maturing in their technical performance, in this decade.
So on balance, it seems unlikely that the Hype Cycle model can be applied to the current situation of the hedge fund industry. However it is possible that the hype cycle applies to some financial instruments – where they are genuinely novel innovations. For example, as we have raised in this blog previously, it is possible that the Hype Cycle applies to the instrument at the epicenter of this recession – the CDO.
I am certainly no expert in financial investment vehicles. So if anyone cares to expand on this debate, I would be very happy to hear from them.