The hedge fund industry has a long history of avoiding tougher
regulation. But as the Obama administration and Congress look for ways
to avoid another financial meltdown, that history may soon come to an

Although it is not clear that hedge funds actually played much of a
role in the current crisis, the industry's sagging performance,
combined with investors' and regulators' heightened demand for
transparency, will likely cause big changes in the way these secretive
investment pools operate, suggest several Wharton faculty members.

Worries about hedge funds are likely to escalate after The Wall Street Journal
reported on March 18 that the now-notorious insurance giant AIG might
use taxpayers' money to make good on hedge funds' bets that the housing
market would fall. At the same time that the government is struggling
to revive housing, it could spend billions rewarding hedge funds that
profit from the housing decline, the paper said.

Critics have long wanted a regulatory crack-down on hedge funds,
arguing that regulators, investors and the public at large know too
little about how this industry influences the financial markets. But
the industry has staved off regulatory pushes, the most serious of
which was a 2005 Securities and Exchange Commission proposal to require
the funds to register with the agency and submit to some scrutiny. The
industry challenged the move, and in 2006 a federal court ruled that
the SEC did not have that authority.

Now the push for regulation is gathering momentum. A bill introduced
on January 29 by Senators Carl Levin, a Michigan Democrat, and Charles
E. Grassley, a Republican from Iowa, would give the SEC authority to
regulate hedge funds. Grassley argues that the political mood has
changed since two years earlier, when he had introduced a similar bill
that went nowhere.

Obama Administration officials also are pushing for tougher
regulation, though how tough is still to be determined. According to
news reports earlier this week, the administration's broader plan for
tighter regulation of the finance industry would include assigning
greater oversight of hedge funds to the Federal Reserve. Stricter rules
might require the funds to make public disclosures. Conceivably, tough
rules could even limit hedge funds' ability to borrow money to
supercharge bets, or even curb some high-risk investments. The guiding
principal will likely be to assure that a fund's activities can hurt
only its investors, not innocent bystanders. And it seems apparent that
any regulation will come in stages, with the initial disclosure
requirements leading to new rules as hazards are detected.

The 10,000 funds control about $1.5 trillion in assets, according to
industry estimates. Hedge funds grew dramatically over the past two
decades as investors sought market-beating returns, but now hundreds of
money-losing funds have shut down and investors are clamoring to get
their money back from many others. The hedge fund industry is really
swooning at this point, says Thomas Donaldson, professor of legal studies and business ethics at Wharton. We're watching an industry whose bubble has popped.

We will see a major shift in regulation in the next year or so, adds Wharton finance professor Richard Marston,
referring to oversight of the entire financial industry, including
hedge funds. I don't really care if the rich in Palm Beach are
fleeced.... I care whether businesses in Philadelphia suffer because
hedge funds have set off a panic in financial markets. Hedge funds
didn't [do that] this time. The banks did it. But next time, it may be
the hedge funds.

The average hedge fund lost nearly 20% in 2008. The
glass-is-half-full camp notes this is only half the loss of the broad
U.S. stock market. Still, it is upsetting to investors who recall the
original goal expressed by hedge funds: to make money even when the
broad markets fell. It was only the second year of losses on record;
the first was a mere 1.45% loss in 2002.

Wharton finance professor Marshal E. Blume
notes that because many hedge funds have shut down in the past year or
two after being virtually wiped out, performance results covering only
the survivors give a better-than-deserved picture. According to one
study, about 700 funds liquidated in the first three quarters of 2008,
a 70% increase from the year before. Some projections say the damage
may have grown to 1,000 funds by the end of the year -- about 10% of
the industry. There's a lot of post-selection bias in the returns on
hedge funds, Blume says. The hedge funds that go bust aren't in those
[performance] numbers.

Role of 'Policy Blunders'

Some of the hedge fund industry's 2008 losses must, in fairness, be
attributed to federal policy blunders in response to the banking
crisis, says Wharton finance professor Richard J. Herring.
He includes among those the decision last September to let financial
services giant Lehman Brothers fail, sparking fear of mushrooming
losses that depressed securities prices. Hedge funds were also hurt, he
notes, by a ban last fall on short sales -- bets on market declines
that are key to many hedge funds' investment strategies. With the ban
on short selling, the liquidity in several markets simply dried up.

Although hedge funds may not be holding the smoking gun in the
current crisis, many experts have worried for years that these pools
could trigger a worldwide meltdown. The first alarm came in 1998 with
the collapse of the Connecticut hedge fund Long-Term Capital
Management, which had made complex bets on bond prices. To avert a
financial tsunami, the Federal Reserve organized a group of major banks
to take over LTCM's assets.

They weren't altruists, Marston says of the rescuing banks. They
were saving their own skin. That's the fundamental case for oversight
of hedge funds.

Though current law does not require hedge funds to register with the
SEC, many do anyway, because their institutional investors require it.
Registered firms are believed to represent about 70% of hedge fund
assets. Because they are open only to wealthy people and institutional
investors, hedge funds have long been exempt from the kind of close
regulation and public disclosure requirement imposed on mutual funds,
exchange-traded funds, annuities and other investments open to
everyone. And hedge funds have wider investment options, using short
sales, leverage and bets on commodities and derivatives that many other
investment pools are not allowed to use.

The theory is that hedge funds are limited to investors who can
afford big risks. I don't think there should be any regulation
preventing informed investors from losing money, says Blume.

But the current financial crisis has put a spotlight on systemic
risk, when the entire financial system is shaken by the activities of a
small group of players, he notes. In today's fast-moving markets,
everything is connected to everything else. The concern is that large
pools of capital can contribute to systemic risk and systemic
downturns. And that's a valid concern.... Hedge funds have a large
amount of money.

If hedge funds' bets can roil the markets, they can hurt innocent
bystanders. Marston notes that university endowments and pension plans
have become heavy hedge fund investors, providing another way for hedge
fund failures to harm ordinary people. He cited one study showing that
the average U.S. university had allocated 15% of its investment
portfolio to alternative investments, which includes hedge funds and
other pools that can be especially risky.

While there's little doubt that hedge funds can be risky for
investors, there is not much evidence they are the central villains in
the current financial crisis, according to Wharton adjunct finance
professor Christopher C. Geczy.
It is not clearly the case that hedge funds caused this crisis, which
I think is the underlying populist sentiment, he says.

Marston and Blume agree. I don't think the hedge funds were the
cause of this current mess, Blume notes, blaming instead government
pressure to boost home ownership, which encouraged loans to home buyers
with poor credit. Those loans were bundled into securities sold to
investors worldwide, and prices for those securities collapsed when
homeowners started falling behind on monthly payments at faster and
faster rates. The hedge funds just bought some of this stuff, he
says, If the hedge funds lose money, that's okay. No problem. It's
when the banks lose money that we have a problem.

Much more blame for the financial meltdown belongs to the investment
banks, Marston suggests. Unsatisfied with profits on traditional
activities like mergers and acquisitions and securities underwriting,
investment banks in recent years acted as if they themselves were hedge
funds, making complex, leveraged bets in their own accounts, he says.

It might have been useful for regulators to have had more insight
into the positions amassed by hedge funds, Blume adds, but the
regulators did know that the banks were creating and selling structured
products based on mortgages and other risky loans. If they'd had more
information about the hedge funds, would anything be different?
Probably not. The current regulatory structure does not address
systemic risk very well, Blume notes, largely because the SEC, other
government agencies and the securities industry's own regulatory
bodies, have traditionally focused on protecting individual investors,
not looking at how the financial markets are functioning as a whole.

Bringing hedge funds under this rubric will not help with systemic
risk at all, because the SEC does not worry about systemic risk, Blume
says. Here's where we're getting into new territory. By definition, if
you are worried about systemic risk, you have to assign such concerns
to one organization, and we don't have that one organization right now.
And, more generally, you have to do it worldwide. The U.S. is very
reluctant to give up any sovereignty to foreign bodies.... Having said
that, the current structure is inadequate. Where we go, I'm not sure.

Various ideas are under discussion in Washington, from simply
boosting authority of existing regulators to giving the Federal Reserve
a kind of umbrella power over regulatory matters. There's even talk of
creating some new superagency. Rep. Barney Frank, a Massachusetts
Democrat who chairs the House Financial Services Committee, wants the
Fed to be assigned responsibility for protecting the stability of the
financial system, with new powers to gather information from hedge
funds, insurers, investment banks and other players. The Obama
administration reportedly wants to be able to show real progress on
this front at the April meeting of the Group of 20 finance ministers.
Administration officials have embraced recommendations for tighter
regulation in a report last year by an international committee led by
Paul A. Volker, a former Fed chairman who now is a top Obama economic

The Madoff Effect

Even without new regulation, the industry is likely to change.
Indeed, it is changing already: To keep investors, many funds have
trimmed their fees from the standard 2% of assets managed and 20% of
profits, Donaldson notes. More people are talking -- as Warren Buffett
has always talked -- about how the fees these funds charge are
horrendous. We are really seeing fees coming down.... There have been a
couple of funds that have waived the 20% part. Some have dropped the
fees [on assets managed] from 2% to 1%.

Funds are also under pressure from investors to loosen rules
restricting withdrawals. Many funds actually tightened the rules --
closing the gate -- after the financial crisis spurred redemptions.
There is anger among investors who have seen the gate close on their
investments, Marston says. Preventing investors from redeeming their
assets when many are desperate for cash will permanently alienate some
of them. Allowing easy redemptions, however, creates problems as well.
The funds can hemorrhage, making it hard, and in some cases impossible,
to engage in complex investment strategies that require a long-term

Finally, there is the matter of just what those investing strategies
are. Traditionally, hedge funds have offered investors only the vaguest
of descriptions, arguing they must keep trading schemes secret to
maintain their edge. That argument, as strong as it is, is giving way
slowly to at least a careful release of information, especially to the
investors themselves, to give investors more confidence, Donaldson

The drive for greater transparency is spurred by the Madoff Effect
-- heightened suspicions after the $50 billion Bernard Madoff Ponzi
scheme came to light late last year. Although Madoff's operation was
not a hedge fund, it employed hedge-fund-style secrecy, and he did
manage money for funds of funds, a hedge fund subset. Now, many hedge
fund investors want to know more about how their money is used and who
actually has possession of securities supposedly in the fund, Donaldson
says. I do think some added transparency with the SEC and other
regulators -- and options to go in and hunt down the devils if we think
they are afoot in the fund -- makes good sense. But hedge funds'
investing options are so wide-ranging it will be difficult to regulate
them very effectively, he warns.

Clearly, these are trying times for hedge funds. But not many
experts think the industry will disappear. Investors will always be
lured by promises of outsized gains, and hedge funds are free to employ
strategies that mutual funds and other investment pools cannot. I
think [hedge funds] are going to be evaluated more carefully by
investors, Blume says, but I don't think the industry's going to fade