WILL HEDGE FUNDS TAKE A DIVE?

By Daniel Kadlec

WITH STOCKS SPUTTERING AGAIN, investors of all stripes are flocking to a familiar fad: hedge funds, which are supposed to deliver decent gains even in bad markets. Yet the "gold-rush mentality," warns William Donaldson, chairman of the Securities and Exchange Commission (SEC), not only threatens our retirement savings but also could one day destabilize the world's money system.

Yes, hedge funds are back--and bigger than ever. You may recall George Soros' minting a $1 billion profit in one month on a bet against the British pound in 1992 and later spurring the ire of small nations, which feared his currency plays would hurt their economy. Then in 1998 major hedge player Long-Term Capital Management self-destructed, and because it had borrowed so heavily, its losses threatened the health of large banks around the globe.

In the years since, hedge funds have kept a low profile, but the dollars have poured in. Hedge-fund assets globally have tripled over the past six years to an estimated $1 trillion, a figure growing 15% to 20% a year. This tidal wave of cash increasingly comes from U.S. pension funds--which since 1997 have raised their stake in hedge funds fivefold, to an estimated $72 billion--and from less-than-rich individuals lured by hedge funds' flashy reputation and falling investment minimums, which were once $1 million but now can be as low as $25,000.

The crush of Everyman money flowing into what can be a risky investment is a big part of what troubles the SEC. Donaldson told TIME the SEC will begin requiring all hedge-fund advisers to register with the SEC before the end of the year. He proposed the rule in July and says that "the preponderance of people" who offered comment were in support. Registering would force hedge funds to disclose information such as their trading strategy, the amount of money they manage and whether they have been disciplined by regulators. "The last few years there has been an increasing number of hedge-fund frauds," notes Paul Roye, director of the Division of Investment Management. "We must shine a light on this secretive segment of the financial world."

Pension managers have come to see hedge funds as their salvation in a deadly period for stocks and bonds. Stocks have lost money over the past five years, and with interest rates rising, bonds are seen as a poor bet. "Pension managers simply cannot afford this kind of setback," says Kevin Mirabile, a managing director in the hedge-fund group at Barclays Capital. The typical pension manager counts on annual returns of 8% or more to meet obligations. That's been a nearly impossible standard since the market peaked, and the nation's pension shortfall has widened to $350 billion.

So pension managers are feeling the heat and turning to so-called alternative investments, like hedge funds, in search of better returns. Most hedge funds try to exploit temporary price discrepancies between, say, a barrel of oil and stocks of oil producers, making money as prices fall back in synch--even if the overall markets are sinking. It's a fairly conservative approach--until a hedge-fund manager attempts to multiply profits by borrowing many times over the amount of assets in the fund. Such borrowing is legal, and even expected, but since Long-Term Capital's meltdown, the Federal Reserve has established safeguards and has been closely monitoring bank lending to hedge funds. Even so, Donaldson says, "there could be a systemic risk coming."

Why? As hedge funds are showered with new money, they end up seeking to exploit the same opportunities, and returns that once routinely hit double-digits naturally fall. It's happening now. Some $80 billion flowed into hedge funds this year through August, and the average hedge fund rose about a woeful 1%. The hedgies are under pressure to pump up returns to justify their steep fees--which run to 2% of assets plus 20% of profits. The SEC's primary concern is fraud, in which a hedge fund hides losses or misstates the value of its holdings. Worse, says Donaldson, is the kind of cheating that came to light in last year's mutual-fund scandals. Some hedge funds had schemed with investment firms to trade mutual funds on the basis of outdated prices, allowing hedgies to profit at the expense of long-term mutual-fund investors.

The pressure to perform--and keep the cash rolling in--might also induce hedge funds to take the more insidious risk of adding heaps of debt--as happened with Long-Term Capital. "You worry about one manager blowing up and having it ripple through the industry," says Mark Anson, chief investment officer at the California Public Employees' Retirement System. A serious ripple could lead to a rapid decline in stocks and bonds as large financial institutions try to unwind their complicated strategies at once.

"The temptation to take on more risk is definitely there," says Nancy Everett, chief investment officer of the Virginia Retirement System, which manages $38 billion, and this year boosted its hedge-fund allocation by two-thirds, to 5% of assets. For that reason, she says, "you should keep an eye on what your hedge funds are up to if you have a hedge-fund program."

Better make it two eyes. In a 2003 survey by Fidelity Investments, 56% of pension managers who invest in nontraditional vehicles like hedge funds conceded they did not fully comprehend the risks. Those risks include the high hurdle of arguably extortionate fees and long periods during which you cannot get your money back, in addition to potential bet-the-farm borrowing.

The wide latitude that hedge funds enjoy is luring big-name money to the industry. Carl Icahn, the 1980s corporate raider who once controlled TWA and Texaco, is raising $3 billion for a hedge fund. He will probably use his new war chest to amass large positions in companies and then agitate for change. And Icahn plans to charge fatter fees: up to 3% of assets and 30% of profits.

By all accounts, hedge-fund leverage is fairly low today, and typical exposure in large pension plans is less than 10%, according to industry watcher PlanSponsor.com But some plans, such as the Pennsylvania State Employees' Retirement System, have as much as 20% in hedge funds, and pension managers generally say they are ramping up exposure. Meanwhile, the level of debt in a hedge fund can change in a blink when a fund manager thinks he or she has a hot idea.

At the funds-of-funds level--at which one fund invests in the shares of many different hedge funds--debt is already mounting. Some are borrowing two or three times their assets, reasoning that they are broadly diversified. Yet if the underlying hedge funds start to borrow as well, it would create leverage on top of leverage, a recipe for cascading losses if things go bad.

These funds of funds hold nearly 20% of hedge-fund assets and are the main vehicle for pension managers and individuals getting into the game. "The funds of funds are taking false comfort" in thinking they're immune from catastrophe, says Matthew Ridley, author of How to Invest in Hedge Funds. "In a crisis, correlations rise abruptly, and everything falls." Stiffer regulation, as Donaldson wants, might at least provide an early warning. Others within the SEC disagree: two of its five commissioners say the new rules will not make a difference. Let's hope some safeguards are agreed upon soon, before the next disaster strikes.