As Hedge Funds Go Mainstream, Risk Is Magnified

NEW YORK -- Hedge funds used to reek of exclusivity. They were run by the most cunning traders on Wall Street, who employed exotic trading techniques designed to make money regardless of whether markets rose, fell or stayed flat. Their clients included only the super-rich.

Those days are over.

Hedge funds are now a $1 trillion industry. Millions of middle-class people invest in them through pension funds or mutual funds.

The Virginia Retirement System, for example, recently increased its investments in hedge funds to $1.6 billion, or close to 4 percent of its assets. The Baltimore City Fire & Police Employees' Retirement System put $80 million into hedge funds last year, while the City of Baltimore Employees' Retirement System invested about $55 million, or 5 percent of its assets.

Some experts say pension funds and university endowments are plowing money into the high-fee funds at the worst possible time. Investment returns have dropped, inexperienced managers are piling in and some sophisticated investors appear to be pulling money out. Hedge funds make -- and risk -- big money by making big bets, mostly with borrowed money. They bet on movements in multiple markets, whether it be in stocks, bonds, currencies, commodities, options, derivatives or any combination of the above.

Estimates suggest that hedge fund trading can account for as much as half the daily volume on the New York Stock Exchange, though as with so much else in the lightly regulated hedge fund world, reliable figures are difficult to find.

Despite the industry's rapid growth, some regulators and financial executives say they still don't know enough about how hedge funds invest, how much fund managers borrow and what might happen if a large number of funds fail at the same time. The Securities and Exchange Commission recently adopted a rule requiring most hedge fund managers to register, but the agency does not routinely require them to disclose their investments or methods, as mutual fund managers must do. Some Wall Street executives hope the new SEC chairman, Christopher Cox, will kill or dilute the rule before it takes effect in February.

Worst-Case Scenario

The regulators and executives say the worst-case result of the industry's blistering growth and light regulation would be a repeat of 1998, when the near-collapse of hedge fund Long-Term Capital Management LP (LTCM) threatened to topple world financial markets.

"Given the absence of transparency across the hedge fund market, we think it would be hard for anyone, including regulators, to conclude with certainty that another LTCM-like event is not possible," said Craig Abruzzo, global co-director of risk management for the prime brokerage unit at Morgan Stanley.

In 1990, there were about 600 hedge funds with $38 billion in assets, according to Hedge Fund Research Inc. Today, there are about 8,000 with more than $1 trillion in assets.

The growth was fueled when the threshold for getting into the funds dropped. "Funds of hedge funds" are now marketed by brokers. They allow investors to put in just $25,000, or even less, for shares in a pool that invests in multiple hedge funds.

Pension administrators have been getting into hedge fund investing as well, in part because of tepid returns from traditional stock and bond investments. Many pension fund administrators are mandated to earn 8 percent or more a year so the fund will have enough cash to pay retirees.