Will Hedge Funds Take a Dive?

With stocks sputtering again, investors of all stripes are flocking to a familiar fad: hedge funds, which are supposed to deliver decent gains even in bad markets. Yet the "gold-rush mentality," warns William Donaldson, chairman of the Securities and Exchange Commission (SEC), not only threatens our retirement savings but also could one day destabilize the world's money system.

Yes, hedge funds are back and bigger than ever. You may recall George Soros' minting a $1 billion profit in one month on a bet against the British pound in 1992 and later spurring the ire of small nations, which feared his currency plays would hurt their economy. Then in 1998 major hedge player Long-Term Capital Management self-destructed, and because it had borrowed so heavily, its losses threatened the health of large banks around the globe.

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In the years since, hedge funds have kept a low profile, but the dollars have poured in. Hedge-fund assets globally have tripled over the past six years to an estimated $1 trillion, a figure growing 15% to 20% a year. This tidal wave of cash increasingly comes from U.S. pension funds which since 1997 have raised their stake in hedge funds fivefold, to an estimated $72 billion and from less-than-rich individuals lured by hedge funds' flashy reputation and falling investment minimums, which were once $1 million but now can be as low as $25,000.

The crush of Everyman money flowing into what can be a risky investment is a big part of what troubles the SEC. Donaldson told TIME the SEC will begin requiring all hedge-fund advisers to register with the SEC before the end of the year. He proposed the rule in July and says that "the preponderance of people" who offered comment were in support. Registering would force hedge funds to disclose information such as their trading strategy, the amount of money they manage and whether they have been disciplined by regulators. "The last few years there has been an increasing number of hedge-fund frauds," notes Paul Roye, director of the Division of Investment Management. "We must shine a light on this secretive segment of the financial world."

Pension managers have come to see hedge funds as their salvation in a deadly period for stocks and bonds. Stocks have lost money over the past five years, and with interest rates rising, bonds are seen as a poor bet. "Pension managers simply cannot afford this kind of setback," says Kevin Mirabile, a managing director in the hedge-fund group at Barclays Capital. The typical pension manager counts on annual returns of 8% or more to meet obligations. That's been a nearly impossible standard since the market peaked, and the nation's pension shortfall has widened to $350 billion.

So pension managers are feeling the heat and turning to so-called alternative investments, like hedge funds, in search of better returns. Most hedge funds try to exploit temporary price discrepancies between, say, a barrel of oil and stocks of oil producers, making money as prices fall back in synch even if the overall markets are sinking. It's a fairly conservative approach until a hedge-fund manager attempts to multiply profits by borrowing many times over the amount of assets in the fund. Such borrowing is legal, and even expected, but since Long-Term Capital's meltdown, the Federal Reserve has established safeguards and has been closely monitoring bank lending to hedge funds. Even so, Donaldson says, "there could be a systemic risk coming."