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Hedge Funds Also Caught in Tempest

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By David Cho and Heather Landy
Washington Post Staff Writers
Tuesday, September 23, 2008

The federal government's dramatic reshaping of Wall Street has thrown the hedge-fund world into turmoil, threatening the viability of some of these massive investment pools that have become increasingly critical for pension funds and endowments and a source of financing for a wide range of consumer loans.

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This year has already been the worst in at least a decade for the $2.5 trillion hedge-fund industry, associations say. But last week's collapse of Lehman Brothers and an unexpected, temporary ban by the Securities and Exchange Commission on the short selling of financial stocks -- a widespread hedge-fund practice that bets a share price will fall -- sent shockwaves through the industry. Several funds are now teetering.

Unregulated and secretive about their trading strategies, hedge funds have enormous sway over the markets. Industry groups say they are responsible for more than a third of stock trades. Some market analysts worry that a collapse of a major fund could shake confidence in an already fragile financial system.

Losses from hedge funds may also quickly spread to other segments of the investment world. In 2007, pension funds had about $76.3 billion in hedge funds, up from about $50.5 billion the previous year. Endowments have invested about $75 billion, according to a recent study.

Some pension funds and endowments that have relied on hedge funds for a stable, higher-than-average source of investment returns have been watching the unfolding trouble with alarm.

As last week's events progressed, Jim Hille, the chief investment officer at Texas Christian University, recalibrated his expectations for returns on the school's hedge-fund investments, which total 22 percent of the university's $1.2 billion endowment.

"The ability for hedge funds to maneuver around changing environments is part of the reason we invest in them," Hille said. "Their benchmark is a double-digit rate of return at a low level of risk, and how they get there is up to them. But there's no question it's going to be very challenging to achieve that now."

Of all of the tumultuous events of the past week on Wall Street -- which included the bailout of the nation's largest insurer, conversion of investment giants Morgan Stanley and Goldman Sachs into bank holding companies, and the promise of a $700 billion rescue package from the government -- the biggest source of problems for hedge funds was the temporary SEC ban on shorting financial stocks.

Industry groups say the ban, if made permanent, could make it difficult for some funds to survive because their entire trading strategy was based on the practice. Hedge-fund managers said shorting plays an important role in the markets because it helps them properly price securities.

Critics of hedge funds say the ban was necessary, accusing short-selling hedge funds of creating a false crisis of confidence at investment banks and profiting from their fall.

Richard H. Baker, president of the Managed Funds Association, the largest U.S. hedge-fund association, said he is pushing for a meeting with the Treasury and the Securities and Exchange Commission to lobby them to overturn the ban, which blindsided many hedge-fund managers.

"I think there's been an emotional response to blame the hedge-fund sector because it's a hard sector to understand," Baker said. "Most people don't understand the relationship our industry has to the working family on the street and the relationship to pensions and endowments."

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