A wise investment?

LEADERS

Hedge funds

Feb 17th 2005
From The Economist print edition

Investors need to become much more sceptical about hedge funds

WHEN an opaque investment fund that does no hedging (in other words, it takes no positions designed to offset other bets) calls itself a hedge fund, charges the sky-high fees of a typical hedge fund and has wannabe customers banging on its door, it is time to ask: what is going on?

The rise of hedge funds is not new. But the funds continue to grow strongly, attracting billions in new money and piquing the interest of investors who, until recently, would never have considered them. Among the new customers are some of America's biggest public pension funds, whose beneficiaries almost certainly have no idea that some of their savings are about to be poured into such murky investments.

As more and more hedge funds are created across a widening range of investment styles, so they are having an ever greater impact on the structure and efficiency of capital markets. With little outside scrutiny, hedge funds can move vast sums at speed as they seek out opportunities.

That can be useful. Authoritative observers, including Alan Greenspan, chairman of the Federal Reserve, credit hedge funds with adding a layer of robustness to the financial system. It is true that hedge funds' willingness to take on risk means that they have been a helpful influence on some bankruptcy proceedings and emergency refinancings. They have also brought much-needed liquidity to neglected corners of financial markets. And their habit of selling against unwarranted price rises can act as a restraint on bouts of irrational exuberance.

But hedge funds can also be risky. The imminent collapse in 1998 of Long-Term Capital Management, a big hedge fund, compelled the New York Fed to step in (perhaps wrongly) with a rescue plan to stop a cascade of other failures. Since then, the hedge-fund industry has mushroomed and become more controversial. Are the high fees which hedge funds charge really justified by performance better than that offered by conventional funds? Can they really protect customers from losing money when markets are falling, as some claim? And, perhaps most pressing, is it right that hedge funds, once sold only to the very wealthy and financially aware, are increasingly being touted as safe for relatively unsophisticated investors?

The answers to these questions are respectively: no; mostly no; and a definite no. Hedge funds have lately been receiving more attention from regulators, and rightly so. Beginning next year, America's Securities Exchange Commission (SEC) will require the management companies of all hedge funds with American customers to register their existence—although not yet details about the actual funds themselves. This newspaper was against the idea of registration when it was first mooted last year. Given how the industry has developed, however, this relatively light-touch form of regulation now seems appropriate. Knowing how many funds there are and who owns them is useful information that is currently impossible to obtain.

But should regulators go much further? Although there is a stronger case today than there was a year ago for more regulatory intervention, on balance it is not strong enough to justify reams of new rules. Tie hedge funds up in too much red tape and they will lose the very characteristics that have made them useful as well as popular. And it is not as if the funds are entirely unobserved. They are subject to anti-fraud law. Moreover, the banks that lend to them and the brokers that allow them to leverage their trading positions all have a keen interest in knowing their customers.

Keeping watch

Such a hands-off approach will look awfully complacent when a big hedge fund blows up, or when some hedge-fund scandal hurts small investors. But strict regulation gives no assurance that those things will not happen. More onerous rules could lull investors to the risks of hedge funds rather than keep them wide awake. Nevertheless, the industry should be watched with special care. It is a cliché to say that the best form of investor protection is caveat emptor; it is also true. In the case of hedge funds the maxim applies with special force. If they took the trouble to inform themselves, many investors would conclude that hedge funds are not for them.

Investors of all sorts, you have been warned. If you want to take your chances with hedge funds, understand what you are doing—and, if you are a pension-fund trustee, do it with liability insurance tucked into your back pocket. All investments need to be watched. Right now, it seems, hedge funds need to be watched more carefully than most.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.