Closer Scrutiny Won't Stop "Hedge Fund Express"

Date: Friday, May 20, 2005
Author: Chet Currier- Bloomberg

May 20 (Bloomberg) -- For all its runaway-train dramatics, the great hedge-fund success story runs on a familiar track.

It keeps passing the same crossings and mileposts reached by mutual funds 10, 15 or 20 years ago. This seen-before scenery encourages the thought that the ``Hedge Fund Express'' has a lot farther to go.

The two are very different vehicles -- hedge funds being designed mainly for the wealthiest, most sophisticated investors, mutuals for the ordinary citizen. The potential for trouble is exponentially larger with hedge funds because of their love of leverage -- and less stringent regulation.

The hazards have been getting great notice of late. Witness the nervous talk in the markets this month that some hedge-fund strategies were unraveling amid unexpected fluctuations in the stocks and bonds of troubled automakers.

William Donaldson, chairman of the U.S. Securities and Exchange Commission, said he was worried about ``the crowding of hedge funds into similar investment strategies.''

``This sort of pressure can lead otherwise well-intentioned professionals to pursue practices that can ultimately result in disaster for the investors that they serve,'' Donaldson said in a May 12 speech. That's a convincing pitch for more disclosure and closer oversight.

Inflection Point

With assets at $1 trillion and rising fast, hedge funds stand at the same point mutual funds reached in 1990. For mutuals, $1 trillion was only the beginning. Today, they are eight times that size, and worldwide mutual fund assets have hit $16 trillion, according to the Investment Company Institute. The rate of growth has slowed, but not stopped, in the last five years even as stock markets around the world declined.

That letdown after the 1990s bull market played right into the hands of hedge funds, which are much freer to operate on both sides of the market. From the end of 1999 through the end of 2004, estimated assets of hedge funds doubled while mutuals grew less than 20 percent.

A doubling of assets in five years is nothing new in the land of mutual funds. They did that or better in every half-decade from 1975 to 2000.

Mutual fund managers were glorified in the 1960s, then vilified in the 1970s as a ``go-go'' bull market in stocks gave way to a punishing decline. Today's hedge fund managers have received much the same kind of all-or-nothing press notices, portrayed alternatively as wonder-working wizards and evil market-wreckers.

Smitten

By the 1980s, a new infatuation phase began with mutual funds, which by this time were recognized as a prime vehicle for investing in bonds and the money markets as well as stocks.

The acclaim began to fade, though, around the time the kitty surpassed $1 trillion. The passing of that milestone signaled that funds were metamorphosing from upstarts shaking up the financial establishment to members of that very establishment.

Much the same thing has been happening lately in the realm of hedge funds, with regulators and the press asking harder questions now that there is $1 trillion in the till.

If the history of mutual funds is any guide, a push for closer regulation of hedge funds shouldn't stunt their growth, no matter how many protests it provokes. The fund industry, even with some glaring instances of trading misdeeds in the past couple of years, has continued to flourish -- helped, not hurt, by the visible presence of cops on the beat.

Clearer View

In hedge funds, there's no telling how much confidence might increase once stronger light is shed on such things as trading strategies involving derivatives.

Why, people might even come to see hedge funds, in their fierce competition with each other, as contributors to the depth and liquidity of the markets, rather than a destabilizing influence.

Can it be only coincidence that measures of stock-market volatility have declined steadily in recent years as hedge-fund assets have ballooned? According to my Bloomberg, the Chicago Board Options Exchange Volatility Index of the Standard & Poor's 500 Index averaged 27 in 2002, 22 in 2003, 15 in 2004 and 13 in the first four months of 2005.

Vanishing volatility creates a problem for some hedge funds, making it harder for them to deliver the kind of returns needed to sustain a glamorous image. Not so for the rest of the world, which may be quite happy to see additional efficiency and liquidity in the investment markets.

To contact the writer of this column:
Chet Currier in New York at  ccurrier@bloomberg.net.