Hedging Concerns

As hedge funds grow in popularity, their secrecy and increasing presence in markets are now raising fears.

July 30, 2006|By LAURA SMITHERMAN | LAURA SMITHERMAN,SUN STAFF

A hallmark of Wall Street lore dating to the Roaring Twenties and the Great Crash has been that the rich and influential trade secrets and make the most from the markets. And if they get burned, so can the rest of us.

The Securities and Exchange Commission, the nation's top markets regulator, was formed after the crash to level the playing field and protect all investors. But now, more than 70 years later, market observers are worried that the secret moneymaker du jour for the wealthy - hedge funds - could cause history to repeat itself.

Hedge funds, or lightly regulated investment pools, manage more than $1 trillion, double the amount just five years ago. They are believed to be responsible for as much as half of the trading volume on the New York Stock Exchange each day.

Last year alone, an estimated 2,073 new hedge funds started up, or about one every 60 minutes during business hours.

The newfound power and reach of hedge funds, and a growing number of scandals, have spurred calls for more regulation. The sheer magnitude of the industry has fostered fears the funds could bring entire markets down. And lackluster returns at some funds, perhaps no better than what an investor would get from a money market fund, have prompted critics to question whether they're worth the massive fees they charge.

SEC Chairman Christopher Cox said last week that he plans to push for new emergency regulation of the high-risk funds after a court threw out a previous attempt to increase oversight.

The long-insular and mysterious realm of hedge funds is indeed losing some of its cover.

Most hedge fund managers closely guard their strategies and take at least 20 percent of the profits. In a global market with deep pockets and complex computer trading systems, they take advantage of anomalies and mispricings, sometimes swooping in with rapid-fire, short-term bets.

A hedge fund is simply a pool of money raised from a number of investors and managed by an individual or group to produce the highest possible return. Unlike conventional mutual funds, hedge managers are not required to make public information on their investments, profits or losses.

Hedge funds bet on almost anything, from currencies and commodities to interest rates and foreign economies. And they are designed to make money, or at least preserve capital, whether markets rise or fall. They use leverage to magnify gains and sell short when they expect markets to be down, essentially betting that prices will fall.

In the opening pages of Hedgehogging, an insider's look into the heady world of hedge funds published earlier this year, investment veterans gather for a dinner and a glass of brandy to gossip about their business and moan about the competition.

They discuss whether too many hedge funds could mean less "alpha" for them, using the industry code for above-market returns that managers get paid handsomely to deliver. One fund manager glumly predicts the current golden age for hedge funds might soon end with a "bang." The scene reveals that some Wall Street pros are privately worried even as the hedge fund industry publicly dismisses negative hype.

Hedgehogging author Barton Biggs, a former Morgan Stanley research head who runs the Traxis hedge fund in New York, contends that hedge funds are no more risky than other investment accounts. While Biggs describes some hedge fund managers as "bizarre characters," he also calls them "brilliant" and "brave."

In keeping with the anonymity that hedge funds covet, Biggs doesn't name many of the people in his book "to protect and to avoid offending or embarrassing the innocent and unwary," he said. To further obfuscate, Biggs said he altered places and dates, and used composite portraits.

For decades hedge funds have been available only to so-called accredited investors who meet net-worth requirements, and many funds required investors to put up hundreds of thousands of dollars. The reasoning: Wealthy investors are presumed to be sophisticated enough to understand the risks unique to hedge funds, or at least to have enough money to hire someone who does.

But who defines "wealthy"?

In this case, the Securities and Exchange Commission defined accredited investors 25 years ago as having a net worth of at least $1 million, or earning more than $200,000 a year, or $300,000 with a spouse.

After years of inflation, and a housing boom that made even some condos worth millions of dollars, however, many of today's middle-class families are wealthy by that definition. Perhaps more important, the idea of limiting hedge-fund investing to the privileged hasn't washed in a nation that prides itself on egalitarianism - and on everyone having the same shot at making a buck.

As a result, the financial business has devised ways in recent years to let in the little, or rather littler, guy or gal.

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