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.
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.
"We are looking for alpha," said Roselyn Spencer, executive director of the City of Baltimore Employees' Retirement System. Alpha is an industry term for the market-beating strategies of skilled managers. "We are trying to meet our 8 percent, so our board decided to look at other investment options."
Spencer acknowledged that the Baltimore pension was getting into hedge funds when returns are flat. The average hedge fund is up about 4.1 percent so far this year, according to Hedge Fund Research, far below the 15-year average of about 15 percent. "We are hoping that it can't get worse," Spencer said.
"Certainly during the bear market, hedge funds held up well because they are structured differently" than traditional mutual funds, said Scott Evans, chief investment officer at financial services firm TIAA-CREF. "But if people are getting in now because of past performance, that is almost always a bad idea."
Spencer said she receives extensive information on the operations of hedge funds in the Baltimore pension's portfolio. But she declined to say whether she was comfortable with the risk level. "I don't have access to that information right now, so I can't comment," she said.
Funds Charge High Fees
Individual hedge funds typically charge high fees, including 2 percent of assets under management and 20 percent or more of returns beyond a certain level. "Funds of funds" can add an additional layer of fees.
Thomas P. Taneyhill, executive director of the Baltimore City Fire & Police Employees' Retirement System, said he was disappointed with the return on the $80 million his system recently invested in "funds of funds." "Performance has been off," he said. "But we are brand new to the area and have to see what happens over time. We wanted to get in [to hedge funds], and I guess a lot of other plans are doing the same thing."
Although most pensions disclose the amount they invest in hedge funds and the name of the hedge fund firms, they generally do not report how the hedge funds invest their money. This is because hedge funds are fiercely protective of their proprietary trading strategies.
Jeanne Chenault, a spokeswoman for the Virginia Retirement System, said the fund does "extensive due diligence" on its hedge fund investments. She would not make an executive available for comment.
Meanwhile, some regulators and analysts are concerned that continued tepid returns from hedge funds could lead many investors to pull their money out at the same time to avoid paying high fees for poor performance, possibly creating a liquidity crisis in which funds do not have enough money to refund investors.
This fear has risen following recent reports suggesting that investors are not putting new money into hedge funds at the rate they once were. A Deutsche Bank survey last month predicted that investors would put $40 billion into hedge funds this year, about one-third the amount invested in 2004. According to Tremont Capital Management Inc., investment in hedge funds dropped sharply in the second quarter of this year, from $24.6 billion in net new assets to $11.6 billion.
"The nature of the shakeout that we see as likely is a run on the bank," said Peter Stockman, a hedge fund adviser at PA Consulting Group. "Investors will start pulling their money out, and that will start rumors and then more investors will pull their money out."
In addition to concerns about liquidity, U.S. and international regulators have held recent discussions with hedge fund managers and Wall Street executives about whether a rapid rise in interest rates or a handful of simultaneous corporate bond downgrades could spark huge losses at funds that bet wrong on rates or held big positions in complex securities tied to corporate bonds.
Big Borrowings Add Risk
They also discussed the amount of money hedge funds currently borrow from big banks to finance operations. (LTCM almost failed in 1998 because it had borrowed 100 times its capital to invest in complex derivative contracts worth $1 trillion. When it could not honor its side of the contracts, federal regulators stepped in and organized a $3.6 billion bailout paid for by Wall Street's biggest firms. That October, Federal Reserve Chairman Alan Greenspan told Congress that regulators organized the bailout because the turmoil at LTCM came just after the Russian government defaulted on its debt, disrupting world financial markets. If LTCM had collapsed, Greenspan said, it could have further roiled markets and damaged the economies of several nations.)
Wall Street risk management executives have assured regulators that they have strict safeguards to ensure they do not have dangerous exposure to hedge fund losses. The executives also say they strictly limit the amount they let hedge funds borrow. But at this point, regulators must take such assurances on faith, at a time when Wall Street has grown increasingly dependent on hedge fund client fees.
Some pension fund administrators are watching hedge funds with a wary eye but not investing. "We're concerned that returns going forward may not be as lucrative as they were in the past," said Steven Huber, chief investment officer of the Maryland State Retirement and Pension System, which has debated but so far declined to invest in hedge funds.