Hedge Fund Industry's Role in Wall St. Crisis

By Nancy Trejos
Washington Post Staff Writer
Saturday, October 25, 2008

Hedge funds seemed unstoppable during the boom years, lavishing riches upon their investors and managers alike. Now that those riches are quickly disappearing, some analysts are blaming them for propagating the high-risk culture that led to the crisis on Wall Street. We try to shed some light on the hedge fund industry.

Q : What are hedge funds and how do they operate?

A: They are private investment funds open to a limited number of people or institutions that can afford to invest a minimum amount of money. Think of them as mutual funds for the wealthy. But unlike mutual funds, they don't have to register with the Securities and Exchange Commission because they are not sold to the public. That means they can sell short, leverage, and undertake all sorts of complicated trading strategies. They are also run by managers who typically get paid higher fees and get a bigger take of profits than other types of fund managers. "What they really should be called are unregistered funds for wealthy people," said John Rekenthaler, vice president of research for Morningstar.

They were named hedge funds because they were supposed do just that: hedge their investments through a variety of methods such as taking both long and short positions. But in recent years, many hedge funds have been doing less hedging and actually adopting riskier practices to maximize rewards. Specifically, some have been leveraging themselves excessively -- investing with borrowed money. "As we know, leverage increases returns but it does the same thing in reverse, maybe faster," said Duncan Balsbaugh, a senior market analyst for Thomson Reuters, IFR Markets.

Q: Why do hedge funds matter so much?

A: Even though the hedge fund industry isn't as massive as the mutual fund industry, it still packs a big punch because each hedge fund operates with such a large sum of money. According to Chicago-based Hedge Fund Research, capital in global hedge funds was $1.72 trillion at the end of September (that was down from $1.93 trillion at the end of June). So when one hedge fund pulls money out of the market, it tends to be a big chunk. Their moves also tend to be made with dramatic flair. "They're active traders compared to mutual funds," Rekenthaler said. "They can have a larger influence regardless of their size because they trade more aggressively."

Q: What is their role in the market turmoil going on now?

A: Hedge funds made risky bets and like many other investors, they are paying for it. Spooked investors are responding by pulling out their money. In the third quarter of 2008, they withdrew $31 billion, according to HFR. The funds have to find cash to meet these so-called redemption requests. They do so by selling their assets. Right now, they are doing just that, which is contributing to the stock market volatility. "They're moving from an aggressive stance to a conservative stance, selling securities and knocking down the price of those securities," Rekenthaler said.

Q: How much are they to blame for the global financial crisis?

A: It's hard to say because they operate under a veil of secrecy. "The problem is nobody knows for sure how much money they hold and where their money is invested and how significantly they're leveraged," said Jeff Fischer, lead adviser for Motley Fool.

But they are not the only ones selling stocks. Many panicked investors, big and small, are following suit. Many analysts also said it would be unfair to single out hedge funds for doing risky things such as overleveraging themselves. Those now-defunct investment banks and other financial institutions are guilty as well.

That said, they could probably use more oversight, said John Jacquemin, chief executive of Mooring Financial Corp., which has a hedge fund. "It's the Wild West out there," he said.

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