Will Hedge Funds Take a Dive?

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Why? As hedge funds are showered with new money, they end up seeking to exploit the same opportunities, and returns that once routinely hit double-digits naturally fall. It's happening now. Some $80 billion flowed into hedge funds this year through August, and the average hedge fund rose about a woeful 1%. The hedgies are under pressure to pump up returns to justify their steep fees which run to 2% of assets plus 20% of profits. The SEC's primary concern is fraud, in which a hedge fund hides losses or misstates the value of its holdings. Worse, says Donaldson, is the kind of cheating that came to light in last year's mutual-fund scandals. Some hedge funds had schemed with investment firms to trade mutual funds on the basis of outdated prices, allowing hedgies to profit at the expense of long-term mutual-fund investors.

The pressure to perform and keep the cash rolling in might also induce hedge funds to take the more insidious risk of adding heaps of debt as happened with Long-Term Capital. "You worry about one manager blowing up and having it ripple through the industry," says Mark Anson, chief investment officer at the California Public Employees' Retirement System. A serious ripple could lead to a rapid decline in stocks and bonds as large financial institutions try to unwind their complicated strategies at once.

"The temptation to take on more risk is definitely there," says Nancy Everett, chief investment officer of the Virginia Retirement System, which manages $38 billion, and this year boosted its hedge-fund allocation by two-thirds, to 5% of assets. For that reason, she says, "you should keep an eye on what your hedge funds are up to if you have a hedge-fund program."

Better make it two eyes. In a 2003 survey by Fidelity Investments, 56% of pension managers who invest in nontraditional vehicles like hedge funds conceded they did not fully comprehend the risks. Those risks include the high hurdle of arguably extortionate fees and long periods during which you cannot get your money back, in addition to potential bet-the-farm borrowing.

The wide latitude that hedge funds enjoy is luring big-name money to the industry. Carl Icahn, the 1980s corporate raider who once controlled TWA and Texaco, is raising $3 billion for a hedge fund. He will probably use his new war chest to amass large positions in companies and then agitate for change. And Icahn plans to charge fatter fees: up to 3% of assets and 30% of profits.

By all accounts, hedge-fund leverage is fairly low today, and typical exposure in large pension plans is less than 10%, according to industry watcher PlanSponsor.com . But some plans, such as the Pennsylvania State Employees' Retirement System, have as much as 20% in hedge funds, and pension managers generally say they are ramping up exposure. Meanwhile, the level of debt in a hedge fund can change in a blink when a fund manager thinks he or she has a hot idea.

At the funds-of-funds level at which one fund invests in the shares of many different hedge funds debt is already mounting. Some are borrowing two or three times their assets, reasoning that they are broadly diversified. Yet if the underlying hedge funds start to borrow as well, it would create leverage on top of leverage, a recipe for cascading losses if things go bad.

These funds of funds hold nearly 20% of hedge-fund assets and are the main vehicle for pension managers and individuals getting into the game. "The funds of funds are taking false comfort" in thinking they're immune from catastrophe, says Matthew Ridley, author of How to Invest in Hedge Funds. "In a crisis, correlations rise abruptly, and everything falls." Stiffer regulation, as Donaldson wants, might at least provide an early warning. Others within the SEC disagree: two of its five commissioners say the new rules will not make a difference. Let's hope some safeguards are agreed upon soon, before the next disaster strikes.