Hello, Hedge Funds

By Barbara Kiviat

When Fortress Investment Group filed to become a publicly traded company earlier this month, it was the Wall Street equivalent of the CIA signing up for Facebook. Being open to the scrutiny of the public is antithetical to pretty much everything that a hedge-fund operator does. But the world of hedge funds isn't what it used to be. Once they were known for being secretive and small--for taking money from millionaires, making winning trades in exotic investments like swaps and warrants and collecting massive fees in near anonymity. The setup was disrupted only by an occasional, spectacular blowup. Over the past four years, though, assets in these funds have more than doubled, to $1.3 trillion, while returns have flagged--and that changes a lot of things.

Confronted with this evolving landscape, hedge funds have had to grow up. You can see it in the way managers trek to Washington for Capitol Hill meet-and-greets. You can see it in the way big-name banks like Morgan Stanley and Citigroup poach existing shops and expand their hedge-fund practices. You can see it in the run-up of bloated, billion-dollar-plus firms. You can see it in how hedgies talk about their industry as if it is an industry, and not an unrelated mishmash of investment strategies.

And you can see it at Fortress, not just because of the IPO but also because the company joins, under one roof, hedge funds and private equity, the practice of buying and running companies. It's yet another sign that lines are blurring and hedgies are no longer the loners of the investment world. Eddie Lampert used his hedge fund to take over Kmart and Sears, then funneled the stores' cash flow into derivatives trades--which last quarter made $101 million, half the company's net income. Nelson Peltz used his to storm onto the board of H.J. Heinz. "By many different definitions," says William Goetzmann, professor of finance at Yale School of Management, "we're seeing the institutionalization of hedge funds."

You're part of it too, albeit indirectly. Pension funds, foundations and endowments--cautious money--flooded into hedge funds after stocks tanked following the late-'90s boom. The institutions were seeking an edge. They didn't get much of one for long: the industry's last year of 20%-plus returns was 2003, according to Hedge Fund Research, and since then funds have on average returned an unflashy 9% a year, partly because the torrent of new money makes markets more efficient.

But for institutional investors like pension funds, with obligations 15, 20 and 40 years out, 9% isn't that bad. They also like the idea that hedge funds provide a cushion in down markets since they don't closely mirror returns from stocks or bonds. David Hsieh of Duke University's Fuqua School of Business studied hedge funds before and after 2000 and found a general decrease in risk.

In other words, now that Big Money is onboard, hedge funds are playing it safer. "Historically, the people who were giants of the industry were unusual, dynamic and hard to classify," says Yasho Lahiri, a partner at law firm Baker Botts in New York City, who represents hedge funds and investors. "Today people want repeatable process."

These new investors also demand details about who is managing their money. "What has been a wake-up call for them is that communication is very much a key part in being able to attract and retain this level of assets," says Rupert Allan, president of Tremont Capital Management, which creates and manages portfolios that invest in other hedge funds.

The intensity of interest from Washington has been another wake-up. Although individuals generally must have at least $1 million in total net worth to invest in a hedge fund, regulators and Congress are sharpening their focus on the largely unwatched vehicles as more run-of-the-mill people become involved through pensions. "Tens of millions of Americans may be unwittingly exposed," wrote the Senate Finance Committee's Charles Grassley last month in a letter to regulators. The Securities and Exchange Commission plans to raise the $1 million threshold for individual investors, and is also working on requiring hedge funds to register.

The concerns are twofold. The first is fraud, which was underscored last year when the principals of Bayou Management pleaded guilty to bilking investors of $450 million by telling some fairly brazen lies. Regulators are examining whether some hedge funds may be making illegal insider trades in certain situations, as when companies privately talk to their lenders.

There is also the worry that a big hedge fund (or funds) could melt down, as Amaranth Advisors did in September when it vaporized $6 billion in a week by making a bad bet on the future price of natural gas. Among the fund's investors was the $7.7 billion San Diego County pension fund, which was out nearly $90 million.

The broader concern is that an Amaranth-type event or series of events would ripple through the system, as in the case of 1998's implosion of Long-Term Capital Management, which zapped more than $4 billion in short order and required a federally engineered bailout to protect the worldwide economy.

Hedge funds play an important role in markets by providing liquidity and contributing to the collective wisdom that figures out prices for everything from companies to coffee futures. This function has only proved more important over the past 30 years, as the number and diversity of financial instruments have surged. But there's a dark side. Complexity and linkages across markets--tight coupling, in the language of systems analysts--make problems more likely to spread to other players, such as Wall Street banks, especially since hedge funds often leverage their investments, which magnifies gains. Or losses. "In most areas, risk goes down over time--airplanes are safer, GDP is more stable--but financial markets have gotten riskier," says Rick Bookstaber, a hedge-fund manager who is writing a book on the topic. "Financial engineering has actually created more risk by adding complexity." Since the summer, the Treasury Department has been meeting with regulators, investors and hedge-fund managers to study this sort of systemic risk.

The response from hedge funds is indicative of their new Establishment persona. They are hiring lobbyists and courting lawmakers--a far cry from the way hedgies dug in their heels in 2004 when the SEC first proposed they register basic information.

Hedge-fund manager James Chanos of Kynikos Associates started a Washington-based trade group this year and so far has 18 fund managers onboard. He has testified before Congress and has been trying to explain that the issues the legislators are raising also apply to other financial players, like the trading desks of big banks, which are essentially internal hedge funds. The message is that taking hedge funds as shorthand for all high-risk investments is failing to see the larger picture. "The business is just too big and too high profile for Washington to ignore anymore," he says. "You have to get a seat at the table"--the grownups' table.