US investors seek a hedge against hedge funds

In some quarters it is being called 'the catastrophe that never happened'. Not yet, anyway.

For 10 days, Wall Street anxiety about a collapse in the over-inflated hedge fund sector has dominated the markets. Rumours of steep hedge fund losses on misplaced bets that stock in troubled General Motors would fall and its debt would rise precipitated a 200-point decline in the Dow; some spoke of a hedge fund 'bubble' whose puncturing would lead to another 2001-style market collapse.

For a guide to potential havoc, investors and fund managers looked to the 1998 collapse of Long-Term Capital Management, the fund whose ill-fated bond bets triggered worldwide panic and Federal Reserve intervention. Still, as of the end of last week, the hedge fund industry still appeared to be sailing along smoothly, for the most part making fund managers and investors happy with its rates of return.

But the loud rumblings of approaching trouble have caught the attention of regulators, who are again looking into whether these lightly regulated funds, with their exotic strategies that use borrowed money and leverage to boost returns, present a threat to the financial market.

According to Hennessee Group, a New York-based consulting firm, hedge funds declined by an average of 1.75 per cent in April, their worst monthly performance since September 2002. The losses, and the potential for more, may curb the willingness of central banks to raise interest rates until they can see how large the threat is.

The scare has reminded investors how little they often know about hedge funds, despite the power they wield in the capital markets. Where they were once high-return funds available only to rich individuals and institutions, they have grown markedly in number and range of purpose in recent years. At the same time, more funds are chasing the same business, inevitably reducing profit margins.

Many fund managers concede that the best years of the hedge fund business are behind them. 'When something becomes so popular, you know you're late to the party,' Scott Black, president of investment firm Delphi Management, told USA Today last week. 'A lot of this is gambling with other people's money.'

In a sense, hedge funds now act as merchant banks once did - providing large amounts of equity to businesses that need to act fast. Their popularity skyrocketed during the last bear market as more closely regulated mutual funds stumbled. But more competition chasing too few investment opportunities is causing some hedge funds to take more risk to boost returns or look further afield - to China - to find opportunities for investment.

As one well-known British fund-of-funds manager points out darkly, the hedge fund business, which remained small and highly profitable for many years, has now attracted every kind of shyster and conman trying to pull off the oldest financial scams in the book.

Wall Street research reports are for the first time adding 'hedge fund insolvencies' to their lists of market concerns. The headline on a report by Lipper Research reads: 'What Equity Investors Need: A Hedge Against Hedge Funds.' The Securities and Exchange Commission's chairman, William Donaldson, warns of possible 'disaster'. According to US analysts, this is what has made the markets so nervous; no hedge fund has so far admitted to being close to collapse, but it is feared that a series of mini-blowups is coming.

Others say these fears are unfounded. Money rushing into hedge funds has grown exponentially, but this has not increased the risk. In the wake of the collapse of Long-Term Capital Management, tighter lending standards and stricter controls of leverage at hedge funds were established, making a panic less likely.

Last week, Federal Reserve vice-chairman Roger Ferguson offered reassurance that hedge funds are 'not a source of instability, nor likely to become one'. The president of Bear Sterns, Warren Spector, said rumours of trading losses at hedge funds were '99 per cent exaggerated'. 'We've done a lot of double-checking and triple-checking to make sure that none of these rumours are true,' he said.

Still, there is no doubt that hedge funds are now experiencing a level of scrutiny and suspicion that they have hitherto avoided. With nearly 9,000 funds, and assets under management doubling over the past five years to roughly $1 trillion, they make for an easy target. Hedge funds, some critics say, have assumed financial power for which they are not truly accountable.

From spiking oil prices to the weak dollar to the resignation of chief executives, hedge funds are being blamed for almost every ill of corporate life. 'They're driving corporate behaviour,' said Donald Hambrick, professor of business at Penn State University. 'The pension plans were aggressive but more genteel. The hedge funds get vicious. They are much more brash.'

By their very nature, hedge funds are susceptible to surprises. When GM's stock surged and its debt collapsed after it was downgraded to junk status, hedge funds suddenly faced a liquidity crisis. And, according to the rumours, so did their lenders.

One of the more widespread reports suggests a major bank was exposed because of its massive and risky lending to hedge funds. Last week, Spector told investors that there had been 'plenty of margin calls and lots of people have been shipping in money' - meaning banks and brokerages are requiring hedge funds to put up more capital to back loans.

What happens next is open to question. If, as happened with Long-Term Capital Management, hedge fund failures begin to restrict the credit markets, central banks will be less willing to put up interest rates. But comparisons with 1998 are only so useful. The scare seems largely due to fear generated by the secrecy that envelops the funds. Without disclosure of who lost what, that fear is unlikely to ease.

'Rumours are nothing new, but you don't hear anyone throwing around any names,' said Bill Hornbarger, head of fixed-income investing at AG Edwards. 'There is a sense of unease. But no one can put their finger on it and say "here is the problem".'