By Amey Stone You may not have a million dollars to invest in a hedge fund. But make no mistake, you're already affected by the vastly unregulated hedge-fund world. These private investment pools, once the purview of rich, sophisticated investors, are booming in popularity. Assets have grown from about $50 billion in 1990 to nearly $1 trillion today. Not only are more ordinary investors participating in hedge funds (often within their pension funds or through lower-minimum "funds of funds"), but the impact of these souped-up speculative trading vehicles on the smooth functioning of the financial markets is becoming increasingly apparent.
"Hedge funds are opportunistic," says Peter Rajsingh, senior vice-president at hedge fund advisory firm Global Partners Group. "They are searching to seize opportunities wherever they can find them and in as high a proportion as they can find them. They are traders, they are not investors." (See BW Online, 8/6/04, "On the Street, the Tough Crowd Rules").
Hedge funds can, and do, employ a wide range of strategies. But by and large, they engage in high-speed, computerized trading to take advantage of short-term market inefficiencies. These strategies have worked for their investors: Since 1987, hedge funds have generated an annual return of 15%, vs. the S&P 500's 12% a year, estimates Hennessee Hedge Fund Advisory Group. But such strategies lead to sharply increased short-term volatility in the markets hedge funds play in. And the funds tend to move in a herd as they seek new opportunities to exploit.
BIG IMPACT. The wild swings in the oil markets in August have been attributed in part to the speculative bets of hedge fund managers. And throughout most of 2004, stock markets have experienced sharp intraday price swings, even as closing-day prices have remained within a narrow band. In a July 30 report, Charles Schwab market strategist Liz Ann Sonders attributed part of the reason to "the dominant participation in trading by the burgeoning hedge fund community" (click here to see a video interview with Sonders).
Hedge funds still represent a small portion of the world's markets (mutual funds, in contrast, have assets totaling $7.6 trillion). But hedge funds have impact far outweighing their size, mainly because they trade so much -- some traders believe they account for half the turnover in stocks -- and also because they often employ leverage, which magnifies their bets.
Meanwhile, competition among hedge funds is increasing as more funds are created (there are now 7,000 funds, up from 5,700 a year ago, estimates Hennessee). That's making funds work harder to find an edge, using every riskier high-speed strategies to get ahead of the market, says Michael Panzner, a trader at Rabo Securities and author of The New Laws of the Stock Market Jungle.
SHADY STRATEGIES. Even as they contribute to short-term volatility, hedge funds affect ordinary investors in other ways. Perhaps more importantly -- and here's where the lack of regulatory oversight is becoming more an issue -- hedge funds often employ strategies that are, shall we say, less than on the up and up.
Case in point: The mutual-fund world is still reeling from a scandal in which fund companies allowed select hedge-fund managers to trade in and out of mutual funds in a way that allowed them to skim profits from those funds. Although not overtly illegal in most cases, the so-called market-timing activity was unethical and essentially prevented long-term mutual-fund investors from earning returns they easily should have, experts say. Hedge fund Canary Capital settled New York Attorney General Eliot Spitzer's case against it for $40 million, and as many as 40 other hedge funds have been implicated in such activities, according to Morningstar.
As new hedge funds spring up to fill demand and competition among them increases, the risk of less-than-reputable or just plain untalented managers entering the field rises, worries Solomon Konig, president of GP Asset Management. It's one reason the Securities & Exchange Commission wants hedge funds to register with them. Right now, the field is far more unregulated than say that of mutual funds. But that could be changing. The SEC proposed July 14 to require registration and is accepting public comment on the plan.
CALL TO ACTION. Registration may be a step in the right direction but in the near term, it won't reduce the potential for hedge funds to heighten market risk and volatility. Even large, well-regarded hedge funds with prominent managers can sometimes go awry. Witness what happened to Long-Term Capital Management in 1998. Its bets on interest rate moves were so highly leveraged that its collapse threatened the stability of world financial markets. According to Hennessee, the average hedge fund now employs leverage amounting to 141% of assets. But Konig notes a worrisome trend: Some funds of funds are adding their own leverage in hopes of improving returns.
There are some positives to hedge funds. They can benefit the markets long term by improving liquidity. They can also benefit individuals with handsome returns, which means it's only fair for more investors to have access to them.
It's inevitable that these sought-after investment vehicles will continue to reshape the markets. But the potential for individual investors and the markets as a whole to be hurt by the lack of oversight is there. Spitzer's actions are a step in the right direction as is the SEC' move to require registration. But more needs to be done in the months and years ahead. Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist