A research report that concluded that $32 billion flowed out of hedge funds in July – leading analysts to think the controversial investment vehicles were a major cause of the global credit crisis that started in August – was wrong, the two firms that issued the report admitted yesterday (Wednesday).

TrimTabs Investment Research and the Barclay Group, the two firms that compiled the report, said the July estimate was calculated incorrectly and apologized. The new data suggests that the impact on the $1.9 trillion hedge fund business wasn’t as bad as some had feared. Rather than a net $32 billion leaving hedge funds in July, a net $39.1 billion flowed into the sector that month, the two firms said.

In August, TrimTabs and Barclay Group estimated that hedge funds had $8.9 billion worth of inflows.

"We apologize for the incorrect hedge fund flow estimates for July," said Charles Biderman, chief executive officer for TrimTabs. "The monthly hedge fund flow data is a new service and the changes we made to our methodology will ensure that our current and future estimates are as accurate as possible."

Because hedge-fund performance had fallen off near the end of July and then soured even more in August as the global credit markets locked up – sparking fears of big hedge-fund redemptions – the July outflow estimates released by TrimTabs and Barclay Group in early September seemed to make sense and were initially accepted. So TrimTabs went as far as saying that the risk-reduction moves undertaken by hedge funds was a key cause of the whipsaw volatility in the stock-and-bond markets as well as the shifting in credit standards globally.

But the firms made two key mistakes in making their calculations, according to MarketWatch.com. The two firms didn’t adjust their estimate to account for the "sub-funds" that many hedge funds use, and whose money flow reports tend to lag significantly. Also, flows were included in the estimates that updated fund performance, but not their assets under management, meaning funds that posted positive returns were incorrectly perceived as posting outflows equal to their asset gains, the two companies said.

Still, since "many investors were probably nervous about putting fresh cash to work until they could assess the fallout from the subprime mortgage mess," the negative impact on hedge funds from the summer credit-market gyrations was clearly visible in the August data the two firms assembled, said TrimTabs President Conrad Gann. The inflow of $8.9 billion for August was the lowest total since January, when $7 billion flowed into hedge funds, the firms estimated. And fixed-income funds posted an outflow of $1.7 billion in August, the firms said.

News and Related Story Links:

• MarketWatch.com:
  Report of Hedge Fund Outflows Was Wrong, Firms Say.

"At present Bear is not holding talks about the sale of a stake to anyone," CNBC reporter David Faber said.
Bear Stearns shares fell as much as 3.4 percent immediately after the CNBC report before closing at $121.15, down 1.5%, or $1.85 per share, on the New York Stock Exchange.

Battered by the collapse of two hedge funds and a disruption in its fixed-income trading, Bear Stearns is seen as relatively weak when compared to other U.S. investment banks, Reuters reported. An outside investor is seen as way to bolster the company.

Bear Stearns shares jumped almost 7.5% Wednesday after the New York Times reported that the investment bank is in talks to sell a minority stake to investors, including Warren Buffett.

The firm is in "serious" talks with several outside investors and could sell as much as 20% of itself, the newspaper said, citing unidentified people briefed on the discussions. Other investors who have expressed an interest in investing in Bear Stearns include Bank of America Corp. (BAC), Wachovia Corp. (WB), and two China-based institutions, the Citic Group and China Construction Bank, the Times reported.

News and Related Story Links:

• Reuters:
  CNBC Downplays Bear Stearns Investor Talk.

• Money Morning News:
  Warren Buffett and Berkshire Hathaway Rumored as Bear Stearns Investors.

• MarketWatch.com:
  Bear jumps on report bank may sell minority stake; Buffett, Bank of America, Wachovia, Chinese groups interested, N.Y. Times Reports.

• MarketWatch.com:
  U.K. Investor Lewis Has 7% Bear Sterns Stake.

• Money Morning News:
  
  Two Bear Stearns Hedge Funds Declare Bankruptcy, a Third Freezes Assets.

• Money Morning Analysis:
  To Make a Small Fortune in Hedge Funds, Better Start With a Big One.

• Bloomberg News:
  
  Bear Stearns May Attract Investment From Buffett, Chinese Banks.

• Money Morning Investment Analysis:
  
  Warren Buffett’s Berkshire Hathaway is Riding the Rails Again.

Expect increased trading volume and market volatility today (Friday) as index futures, market index options, stock options, and stock futures all expire on the same day.  While index futures and options typically share simultaneous expirations on the third Friday of every month, quadruple witching days usually only come about on the third Friday of every March, June, September, and December.

Many investors scramble to unwind their positions in their contracts before they expire, which includes repurchasing contracts and closing out other positions used to hedge against those contracts. So, quadruple witching days are usually marked by periods of volatility in stock and derivative prices, and increased trading volumes.

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Not everyone’s a loser in the U.S. sub-prime saga.

HFA Holdings Ltd. (ASX: HFA), an Australian hedge-fund manager that manages more than $3 billion, said it anticipated the U.S. sub-prime mortgage crisis two years ago, a prescience that enabled its funds to reap the benefits of the credit crisis that’s even now roiling the global capital markets, Bloomberg News reported early today.

The Sydney-based HFA saw its shares leap 17% on Australian exchanges after the hedge-fund manager said it essentially “shorted” sub-prime securities – essentially borrowing and selling the securities it didn’t actually own at high prices, betting it could replace the shares at a much lower price after the securities cratered. The difference between what it took in by selling the securities and what it paid to replace them is its profit on the transaction, or series of transactions.

"Our investors will be well rewarded by their allocations to HFA’s absolute return funds over the coming 12 months,” HFA said in a company statement to Australia’s stock exchange.

The company said its investments in collateralized debt obligations and residential mortgage backed securities resulted in a net short position.

HFA Managing Director Paul Jensen last month told the Australian publication TheAge.com that HFA Holding’s Australian funds didn’t have significant exposure to the U.S. sub-prime mortgage market. Jensen told the newspaper that the credit markets made up a very small proportion of HFA’s exposure to global hedge funds.

“As I said before, the exposure of the (HFA Diversified) fund is across multiple strategies, long/short, event driven, and as I did say, with no exposure to credit," Jensen told Sky News. "With … the last six months, the sub-prime issue has arisen in the U.S. (market) … from our perspective, we have been well positioned for that and have made money over the last six months.”

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As a global trader interested in aligning my money with the most powerful trends of the day, I’m constantly watching the headlines in search of the latest moneymaking opportunity.

I am particularly interested in stories that emblazon the front pages of newspapers everywhere else around the world, but that barely even rate a mention here in the United States. So often, this signals an important investment opportunity that the “herd” has yet to discover. I like to call this my “Rule of the Back Page.”

The ongoing Barclays PLC (NYSE: BCS) /ABN AMRO Holding NV (NYSE: ABN) saga is a terrific case in point. Although the deal isn’t done, the way it’s been structured – with private-equity financing from the China government – suggests there are powerful changes looming in the financial markets. And that means there will be new ways for savvy individual investors to profit in the years to come.
 
The essence of this fascinating financial tale is this: The China Development Bank just plunked down $3.03 billion to buy a stake in Barclays, an old line European banking legend. Factor in China’s recent $3 billion investment in The Blackstone Group LP (NYSE: BX), the U.S. private-equity powerhouse, and savvy market-watchers will suddenly realize the Chinese government has achieved several key objectives. Indeed, China has:

• Purchased unprecedented access to the global financial markets.
• Acquired what’s arguably the very best investment-banking expertise in the world.
• Lined up a steady flow of opportunities for its $1.3 trillion in foreign reserves (an amount that’s reportedly growing by another $200 million every six months).

To give you an even better understanding of the deep game that China is playing, consider this: With the $3 billion investment from the Chinese government, Barclays has been given the equivalent of an open hunting license in China, which desperately wants (and needs) to modernize its commercial banking industry.

But Barclays isn’t the only one that gains here: With its shrewd maneuverings, China is a “stealth” beneficiary. You see, because China is now a valued Barclays shareholder, any outsized profits that accrue to Barclays also accrue to China’s government-investing operation.

And that’s above and beyond the gains in commercial-banking and capital-markets expertise that we already mentioned. All of these things were previously unavailable to the Chinese.

Where the rubber meets the road as far as I’m concerned is that deals like Barclays and Blackstone provide us with an important early insight into a favorite strategy of mine: Making money by investing in companies that will benefit “because of” China. And that’s a strategy that will lead to much greater short-term profits – and at a much lower rate of risk – than strategies that focus solely on investing “in” China.

[Editor’s Note: Watch for a new investment-research report by Keith Fitz-Gerald on this very topic in the near future. Fitz-Gerald will not only detail the strategy itself, but will also outline the companies best positioned to benefit. The research report, and the accompanying recommendations, will be free of charge to all Money Morning subscribers.]

The Background on Barclays

London-based Barclays is courting ABN AMRO, a 183-year-olf Dutch bank, but so is Barclays arch-nemesis Royal Bank of Scotland (LON: RBS). As of early August, both parties were offering almost-unfathomable amounts of money in what may ultimately be the richest buyout in financial history.

But it wasn’t always that way. In fact, back in April, Barclays was ABN’s only suitor. The problems surfaced in July, when RBS trumped Barclays by showing up with a higher offer of its own for ABN.

Barclays execs were forced to scramble and find additional money for a boosted bid. Their search took them to the other side of the world, and to the most unlikely of sources for private-equity capital: The government of China. Indeed, the China Development Bank agreed to help Barclays up the ante, and kicked in some $18.76 billion in cash.

At present, the Barclays bid is estimated at $92 billion, of which approximately 37% is in cash. RBS is offering roughly $97 billion (give or take a few dollars, depending on the exchange rates of the day, thanks to a financing consortium that includes Banco Santander SA of Spain, and Fortis NV, which also is Dutch).

But where Barclays wants ABN lock, stock and barrel, the RBS-led consortium wants to take ABN apart, and split it amongst the participants, much like a pack of wolves would split up the carrion of a kill.

Interestingly, the ABN board initially favored the acceptance of the Barclays’ bid, noting that it was consistent with ABN’s “strategic vision.” But the board has apparently had a change of heart in the past few weeks. This doesn’t particularly make sense, given that ABN CEO Rijkman Groenink is on record as saying that he prefers the lower Barclays’ bid because it carries less “execution risk.”

But then again, few things rarely make sense in the hidden world of mergers and acquisitions.

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When $5 Billion Less is a “Better” Deal

In effect, Groenink is saying he’d sooner take a $5 billion hit and leave money on the table than risk a failed transaction and the possibility of more money at the day’s end. This suggests there’s more to this deal than meets the eye….and there is – especially if you take the time to “read between the lines.”

What the ABN CEO isn’t saying (but is most certainly thinking) is that he’ll take the Barclays deal backed by the funding from China, because he knows the cash-rich Chinese are good for it and that there’s almost no chance the deal will fail. Besides, I’m betting that he also believes Barclays has the $5 billion in question, and that someone will simply pony up the additional cash when the time comes – no questions asked.

Clearly, too, he’d rather take the certainty of the well-funded deal over the uncertainty of an extra $5 billion from a consortium that will likely break up his bank when the deal is done.

His board of directors, on the other hand, seems to want the additional $5 billion.  However, rumor has it that the directors are also concerned that China’s involvement in such a deal is a “national” problem along the lines of the U.S. concerns that essentially forced the China-controlled CNOOC Ltd. to drop its $18.4 billion bid for Unocal Corp. two years ago…at least if you believe the global grapevine.

And the Barclays board has some major concerns of its own. They have to realize that if their gambit fails – and RBS ends up as the triumph bidder for ABN AMRO – that Barclays itself will end up as a takeover target. It’s the ultimate irony, but it happens all the time. Since former Barclays director Justin Urquhart-Stewart was recently quoted as saying as much, I’m certain I’m right on that point.

It’s the oldest story in the M&A world…the hunter becomes the hunted. If one suitor that’s going for growth strikes out in its bid for a company, it suddenly finds itself bore-sighted by other players who sense its weakened condition … just like circling sharks who sense when there’s “chum” in the water. One case-in-point is PacificCorp., which spent more than $300 million in failed bid for Britain’s Energy Group – and wound up being taken out by Scottish Power.

Both ABN AMRO bids have their strong points, and that’s what makes this affair so very interesting. In true Asian fashion, the circle truly does go around, so bear with me as I bring this full-circle and close the loop for you.

The ‘Great Wall Street’ of China

By agreeing to help Barclays pursue ABN AMRO, China’s Development Bank is demonstrating a very sophisticated understanding of how the world’s capital markets work, as well as a real willingness to do what it takes to “play with the big boys.” What’s more, despite cultural norms that in the past would likely have prompted China to withdraw from the international deal arena after it “lost face” by failing at its first deal, the Barclays bid for ABN demonstrates a newfound shrewdness and newly acquired willingness to learn from its mistakes.

For instance, the China Construction Bank purchased Bank of America’s Hong Kong and Macau branches, while Singapore’s Temasek Holdings acquired a 12% stake in Britain’s Standard Chartered Bank – becoming the largest shareholder in the process. Of course, people are more familiar with the Blackstone infusion made by China’s State Investment Company, a deal that made headlines around the world.

But here’s where it gets really interesting: What few folks realize is that Blackstone served as the China Development Bank’s financial advisor when it made its initial $2.2 billion investment in Barclays.

Hmmm…see a pattern here? I thought you would …

What’s happening is uniquely Asian and Chinese on one hand, with a smidgen of Gordon Gekko mixed in for flavor. Not only have the Chinese waded into the world’s capital markets with amazing speed, but they are apparently unafraid to bring substantial resources to bear in the process.

This represents a marked change from historical norms in which the Chinese operated largely inside their own sphere – inside their own borders, where they were content to implement their own relatively primitive and ineffective changes in what was a highly protected financial market. These surprising developments also suggest a willingness to learn from “the best,” which, in the ultimate irony, means us.

In traditional China, a failed deal like the afore-mentioned move on Unocal would once have represented such a loss of face that any attempts at global dealmaking would have ceased right then. But China’s budding financiers had a real revelation: The nation’s politics and human rights reputation very likely made it an undesirable outright suitor, or direct partner. But, by stepping in behind an acceptable “front man,” China was one giant step removed from any financial transaction. And when that front man is an all-American wheeler-dealer like dealmaker Blackstone, well, it suddenly doesn’t matter as much who you’re bringing to dinner – or to the deal table.

Why China of 2007 Isn’t Japan of 1987

While many investors are stunned to see the Chinese on the financial scene in such a big way, longtime global market makers aren’t surprised at all. Indeed, they’ve been expecting this for some time.

You see, they recall all too well what happened back in the late 1980s. If you recall, like the Chinese now, the Japanese then were flush with cash and were buying everything that wasn’t nailed down – and even a few things that were.

I know…I was there in the institutional markets helping them do it.
 
Almost overnight, the newly wealthy Japanese were viewed with fear. Americans talked about the invincible “Japanese superman,” an unstoppable juggernaut who never made mistakes. Japanese cars filled American roadways, and Japanese-owned companies started buying up all sorts of high-profile “trophy” assets: Universal studios, Columbia Records, Rockefeller Center and the Pebble Beach golf course (with its lonely cypress tree) all had new ownership. Lawmakers sounded the alarm, and so did the U.S. news and entertainment media. Fortune magazine carried a piece entitled, “Where Will Japan Strike Next?”And author Michael Crichton’s alarmist book, Rising Sun, was made into an equally alarmist – but no less fun to watch – feature film that starred Sean Connery and Wesley Snipes.

Several things make it different this time around, with China:
                

• First, while Japan had the money to pull off the deals, it didn’t have the economic backing to sustain them. So it’s no surprise that Japan’s economy fell off a cliff for 15 years, and has only recently started to claw its way back to its prior heights.     But China, on the other hand, boasts an economy that’s growing at three times the speed of its U.S. rival. And, by most estimates, it can continue to grow at this pace for several decades to come.
• Second, the Japanese buying spree of the late 1980s was confined largely to hard assets, with only a smattering of actual corporate buyouts mixed in. Perhaps the fatal flaw was that Japan just couldn’t get past the notion of intrinsic growth, and never lost its preference for growing things internally. Had Japan been able to get past this mental roadblock, it might actually have ended up with the global diversification necessary to stave off the worst portion of its long depression – but that’s merely conjecture on my part.
• Third, China is avoiding the other key missteps that Japan repeatedly made. The Chinese are not only buying the companies they need, they’re snapping up the required resources and intellectual capital, too. In marked contrast to the mid-1980s Japanese, China’s business leaders of today have no qualms about buying the intellectual advice they need to make sure they’re deploying their cash in the most efficient places possible. What’s more, they are not confining their efforts to hard assets as the Japanese did and that means individual investors can grab a piece of the action along the way.

The Next Places to Profit

Speaking of which, I think the next great wave of Chinese acquisition targets will be Canadian resource companies valued between $200 million and $1 billion. Not only are they financially transparent, but many of these companies possess reserves valued above and beyond present cash flows. And when a potential suitor wants these properties as badly as China clearly does, they will pay up – meaning that these companies will go out at a value greater than anything we’d ever think to calculate using our conventional valuation models.

The pace of those deals will start accelerating in the very near future.

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Contributing Editor Keith Fitz-Gerald, a brand-new addition to the Money Morning research team, is one of the world’s foremost experts on the Asian markets, especially China and Japan. A professional trader who works with wealthy investors and institutions, Fitz-Gerald is also a seasoned market analyst known for his accuracy, perspective and insight, Fitz-Gerald is also a professional trader who has worked with high-net-worth investors, and who’s also advised major institutions. A truly global investor and an expert on Asia, he and his family split their time between Portland, Oregon and Kyoto, Japan.

Two Bear Stearns Cos. hedge funds filed for bankruptcy Wednesday while another froze its assets. The Bear Stearns High-Grade Structured Credit Strategies Master Fund Ltd. and the Bear Stearns High-Grad Structured Credit Strategies Enhanced Leverage Master Fund Ltd. have filed for protection under Chapter 15 of the bankruptcy code.

It became evident that the sub prime crisis had spread to other sectors of the prominent hedge funds when the company began telling investors that of the two now bankrupt funds one was essentially worthless and the other had lost more than 90% of its value. The funds relied heavily on securities backed by risky sub prime mortgages and were devastated when defaults on sub prime loans rose to a ten-year high.

The third fund, the Bear Stearns Asset-Backed Securities Fund, is hardly related to the housing market at all, but withdrawals were halted after investors started to panic. The fund has approximately $900 million invested in securities, 0.5% of which relate to the sub prime market. It was up 5% this year through June, but began to drop in July as investors began to look for escape routes.

News of the halt in withdrawals came after the close of the stock market’s regular session Tuesday, during which Bear Stearns shares sank $6.03, or 4.7%, to $121.22. In after-hours trading, the stock slid 3.5% to $116.95. However, the fund isn’t carrying any debt and reportedly holds about $50 million in cash and gets $13 million in principle and interest monthly.

Hedge funds and private-equity funds are both a sucker’s bet. As an investor, the best thing you can do to profit from these “alternative” investments is to avoid them altogether.

While I realize this isn’t a widely held viewpoint, it is one that’s gaining support. Just ask “perma-bear” Jeremy Grantham, the Boston-based money manager who supervises $150 billion in investments for Grantham, Mayo, Van Otterloo & Co. LLC. In an interview published earlier this week, the 68-year-old industry veteran predicted that the spiraling credit crunch could cause half of all existing hedge funds to close within five years.

Hedge funds “are piling on risks of different kinds and presenting it as out performance,” Grantham told Bloomberg News. “In a weak world [made weaker by a credit crunch], they pay the price of all the risk they’ve taken …they melt down.”

Indeed, the meltdown has already started.

Two hedge funds operated by investment bank Bear Stearns – wiped out when they made a big bet on the now-highly troubled sub prime mortgage market – filed for bankruptcy protection yesterday (Wednesday), while the assets of a third were frozen by the company (for a more-detailed report on Bear Stearns’ hedge fund woes, click here).

In today’s global capital markets, havoc can be wreaked in a flash. On Monday, Hedge fund Sowood Capital – which managed an unspecified portion of Harvard University’s $30 billion endowment – revealed it would shut down after a month in which lousy bond-market bets vaporized half its assets. In less than four weeks, Sowood reportedly saw its assets plunge from $3 billion to about $1.5 billion. To save what was left, the firm sold out to Citadel Investments Group, a hedge fund operator that manages assets of about $14 billion. It was Citadel that stepped in to rescue the energy portfolio of failed hedged fund Amaranth Advisors last year.

The Basics: Hedge Funds Math

If your broker hasn’t tried to talk you into investing in hedge funds, yet – and you have more than $1 million in “investable” assets – don’t worry, he soon will. After all, this is now a $2.4 trillion investment pool, and as you’ll soon see, your broker has a huge incentive to bring you into the fold.

He’ll probably call them “uncorrelated assets,” and will explain that their returns have very little to do with the general performance of the major U.S. stock indexes. For that reason alone – to “protect” a portion of your assets from any domestic-market nastiness – you really had to become a hedge fund investor.

But no matter what your broker might try and tell you about the hedge funds he’d like you to invest in, the reality is this: Since this type of fund is so profitable for the management group that runs them because of the hefty fees they’re able to charge, it should also be clear that they are quite profitable for the brokers who sell them. So you needn’t worry that you might be missing out on a truly exciting investment opportunity.

The term “hedge fund,” itself, is really quite a misnomer: Unlike an options-oriented “hedging” strategy that a company or a sophisticated individual investor will employ to protect their investments against a market downturn, hedge funds really don’t offer the same counter-balancing bets.

The truth is that the term “hedge fund” is used as a kind of loophole. It distinguishes them from such retail offerings as mutual funds, which are open to most all retail investors, which are therefore heavily regulated as a result. Hedge funds are only open to qualified, or “accredited” investors, most of them wealthy. Thanks to this limited potential audience, hedge funds are largely free of direct oversight by regulatory authorities, and can operate in a great deal of secrecy. They are free to charge large performance fees, and can utilize strategies that are much more complex and often take on much greater risk than the mutual funds most retail investors are familiar with.

But the biggest secret of all – and one that your broker almost definitely won’t reveal to you – is that the average hedge fund return isn’t very exciting: It was just under 12% in 2006, and was only 4.5% in the four months to April 2007, according to one report. By comparison, the Standard & Poor’s 500 Index returned 15.8% for all last year, and was up 5.1% in the first four months of this year.

However, due to a factor known as “survivorship bias,” the “real” hedge-fund results are probably actually much worse than most research shows. You see, hedge funds that disappear during the year – logically speaking, the worst-performers of the lot – are taken out of the results, a fact that very likely skews the results and makes them appear much better than they actually are.

Barclays Capital has calculated that hedge fund returns are overstated by as much as 2.4% per year, which takes the forecasted 12% return all the way down to 9.6%. Now go in and subtract the 2% management fee and a 20% performance fee (20% of the 9.6% average hedge fund return), and you’re down to 5.7%.

Now get this: Because of the way those management performance fees are calculated – that 20% management fee isn’t refunded on losers – even the average annual return of 5.7% that we’ve cited here is far too high.

Look at it this way. Let’s say that you’ve made equal investments in three hedge funds that as a group have generated an average annual return of 9.6%. But one fund returned 50%, the second 28.8%, and the third lost 50% of its principal value (the average of which is 9.6%). You might just think that the management fee on an equal investment in all three funds would be 20% of the 9.6% average return, or 1.92% (20% x 9.6% return = 1.92% performance fee for the fund managers). But it doesn’t work that way.

Instead, your management-fee charge for your investment in the three funds would look more like this. You’d pay 20% of (50%/3 funds) plus 20% of (28.8%/3 funds), or 5.25%. And that knocks your net overall return down to 2.35% – quite a difference from the 12% that you foolishly might have been anticipating.

To pretty it up and make it look all the more attractive, brokers will often quote you the so-called “top-quartile” investment return. That’s the return made by the top 25% of all funds. If you invested at random, you would have had a 25% chance of achieving this performance. The broker may even compare this top quartile figure to the top quartile return generated by conventional mutual funds.

This is the stockbroker’s version of a “carny” trick. He does this because hedge funds invest in such a wide variety of different things that their returns have more “dispersion” than stock funds – in plain English, they’re riskier – so that the top quartile is further above the median for hedge funds than for stock funds.

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The Problem With Private Equity

As an alternative to a “hedge fund” your broker may try to get you to invest in a “private equity fund.” These don’t invest all over the place, like hedge funds, but instead buy whole companies, “improve” their operations and sell them again. Private equity funds have one advantage over hedge funds and two disadvantages. The advantage is you have a rough idea of what they are doing: Their strategy isn’t secreted away in a so-called “black box” that’s filled with incomprehensible, pseudo-mathematical jargon.

One disadvantage is that to return a profit they must either sell the company they’ve bought on the stock market via an Initial Public Offering (IPO) of stock, or to other companies whose shares are listed on the stock exchange. That means that these funds are also not really “uncorrelated” investments, as they so often claim private equity funds to be. And in a bad market – such as the downturn of 2001-2002 – they can do appallingly badly.

The other disadvantage is that, as well as benefiting from the same “20% for us if we win, nothing for you if we lose” fee structure of hedge funds, private-equity fund managers are rewarded with performance bonuses that are based on the value they’ve added to the companies they’ve acquired with the intention of later selling.

To assess this, the fund managers hire “tame” accountants as business-valuation consultants, and then ask these advisors to estimate the company’s value. Since the accountant’s fee is based on the value of the company, he’s got a real incentive to make and justify a very high estimated value. Management gets paid its performance bonus based on that estimate. So even if the company ends up selling for a lot less – even at a breakeven price, or still worse a loss – management has already been paid. So even when private-equity-fund investors don’t receive any money, the fund’s managers still win.

As an avid Red Sox fan, I have been heartened by the team’s renaissance in recent years, a turnaround fueled by the untold billions of their new principal owner, John Henry, a hedge fund mogul who bought the team in 2002. He’s rich like New York Yankees owner George Steinbrenner. But because Henry made his fortune via hedge funds – while “The Boss” inherited his (thanks to a shipbuilding company) – we BoSox fans like to think that John is smarter than George.

But there’s one flaw in that logic. As the title to Fred Schwed’s 1940 investment classic asked: “Where are the customers’ yachts?”

Since December 2004, two months after the Red Sox exorcised the “Curse of the Bambino” and won their first World Series since 1918, Henry’s funds are down more than 35%. What’s more, over the last decade you would have done better buying an index fund or investing in Treasury bonds than investing in Henry’s funds. For this service, Henry charges the usual hedge fund fees of 2% of assets under management, plus 20% of the profits – indeed he is sometimes credited with inventing that typical hedge fund fee structure.

This is, of course, bad news for the Red Sox: Brett Arends, of TheStreet.com, recently said that Henry’s assets under management had declined from $2.9 billion to $1.4 billion, so there may well be no more $103 million Japanese pitchers in the team’s future. However it’s even worse news for Henry’s investors, particularly those who bought in 2004, when performance really started to decay.

In short, hedge funds and private equity funds are both a mug’s game and should be avoided.

 If you want “uncorrelated assets” you should look at some top-quality stocks from some of the Asian markets that are still trading at very reasonable levels: Such countries as Japan, Korea and Taiwan haven’t seen their indices streak into record territories, and are not trading at the same pricey levels as their U.S. rival.

It’s true that their returns are not completely uncorrelated with the U.S. markets, because today’s global money market is just one gigantic muddy pool. But my very detailed research shows that at least the domestic economic situations in these three countries – as well as the political factors that affect them – are very different than those facing the United States.

As for private equity funds, they are a good investment only in the depths of the most-terrible markets – like in the late 1970s and early 1980s, when stocks were so disdained that Business Week magazine actually carried its now-famous cover story, “The Death of Equities.” It’s during those periods that you’ll find lots of companies available at very cheap prices. But, of course, we are nowhere near that state at present.

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