Quotes of the Day

Hedge-fund managers will not look back on the summer of 2007 with fond memories. The first half of the year had gone pretty well. Investors had poured record amounts into the funds, to the tune of $135 billion through July, exceeding the total $126 billion that flowed into the sophisticated, shadowy investment vehicles in all of 2006. Most hedge-fund managers were enjoying solid returns: the industry averaged a 7.37% gain through the first seven months of the year, according to Hedge Fund Research (HFR), a Chicago research firm. That was nearly double the performance of the benchmark S&P 500 index, which returned 3.84% over the same period.

Then the subprime credit crisis hit, and suddenly some high-flying hedgies had their heads handed to them. Two Bear Stearns hedge funds worth a total of $1.5 billion collapsed due to their exposure to toxic subprime debt, a debacle that was preceded by the subprime-fueled demise of a hedge fund run by Swiss bank UBS. Basis Capital, an Australian firm with more than $2 billion in assets, was forced in August to liquidate its Basis Yield Alpha Fund, which had previously been one of Australia's best-rated hedge funds. Numerous quant funds, which use computerized analysis to make investment decisions, posted big losses as stock markets reeled from the subprime mess.

As if that wasn't enough, the tremors came at a time when hedge funds were under increasing scrutiny by politicians and regulators concerned about their growing impact on global financial markets. With total assets of more than $1.8 trillion, the industry has nearly doubled in size since 2004, and the activities of hedge funds can increasingly move markets. The danger posed by these lightly regulated vehicles, which employ strategies such as short-selling, trading in derivative securities, and leverage, to the financial system has been demonstrated before — most vividly by the 1998 implosion of Long-Term Capital Management (LTCM), a giant American hedge fund that lost $4.4 billion in six weeks and had to be bailed out with the help of the U.S. Federal Reserve to avert a market panic.

Although financial-market stability appears to have returned, for a few weeks this summer an LTCM-like collapse seemed like a possibility as the credit crunch intensified. That's one reason why there's growing urgency to understand how these huge pools of private capital can disrupt markets. In the U.S., California lawmakers and regulators are pushing a proposal that would require larger hedge funds that have fewer than 15 clients to register and to open their records to state oversight. In Europe, the German government is spearheading an inquiry into the subprime crisis by the G7 group of industrialized nations. While hedge funds were not at the center of the credit crunch, "It's the duty of the G7 to look at where there could be black holes in financial markets and black holes are always the source of future crises," says Thomas Mirow, Germany's deputy finance minister. As G7 president, Germany has been lobbying for greater hedge-fund disclosure and transparency.

Fearing that more controversy could lead to regulation, the industry is fighting back. Led by former Bank of England deputy governor Andrew Large, a group of 14 major U.K. hedge funds recently floated a code of good governance that promises greater disclosure to investors by offering more information on the risks funds may be exposed to. The code also calls on hedge funds to voluntarily disclose interests in companies held through indirect investments, to bolster strategies to weather big market swings, and to detail procedures followed in putting valuations on illiquid assets such as subprime debt, among other provisions. "We certainly hope that this might reduce somewhat the appetite of governments to regulate," says Large. Meanwhile in the U.S., a government-sponsored industry group, the President's Working Group on Financial Markets, is also preparing a set of voluntary hedge-fund guidelines. "Regulation can be a blunt instrument," says Russell Read, chief investment officer for the California Public Employees' Retirement System (CalPERS), a $240 billion California pension fund that invests in hedge funds. "We think investors and hedge-fund managers themselves will have the best and hopefully the highest impact" in improving the industry's practices, says Read, who is chairman of the Working Group's investor committee.

The fallout from the summer's subprime mess may go beyond unwanted government attention, however. Hedge funds posted losses averaging 1.32% in August, according to HFR data, a setback that appears to have at least temporarily dented the confidence of the big banks, insurance companies and pension funds that are the main hedge-fund investors. The flow of new money into the industry, which had gushed all year, fell sharply, by more than a fifth, in the third quarter. It was as if investors, spoiled by years of strong profits, took a step back to reconsider their situation. "Most likely we will now see a reallocation of capital to funds that did well in the period of volatility," says Kenneth Heinz, president of HFR.

Indeed, hedge funds in their original form were designed to reduce investment volatility by profiting in bear markets as well as bull. But some wonder if the industry is in danger of becoming a victim of its own success. The number of funds has swelled from 6,297 in 2003 to nearly 10,000 today, raising concerns that an influx of young, inexperienced managers will find it increasingly difficult to post market-beating returns. Managers charge a lot for their expertise — typically a 2% annual management fee plus 20% of profits. But with funds multiplying in both diversity and complexity, industry insiders expect competition to force less successful funds to start reducing what they charge their customers. A recent survey of 100 large-fund managers conducted by consultants Ernst & Young found that 72% expected a drop in management fees and 80% expected performance fees to fall.

Throw in the fact that disappointed investors will likely migrate to those funds that did well during the recent bout of volatility and you have a shakeout scenario. Huw Van Steenis, an asset-management analyst with Morgan Stanley, told a forum of European hedge-fund managers in October that a "super-league" of funds is slowly taking control of the industry. In 2006, 67% of all assets under management were controlled by this élite group of the top 100 funds, compared with 49% in 2003. "We think there's going to be a Darwinian process, a sorting out of those who are actually producing a respectable performance and those who are not," says Giles Conway-Gordon, managing partner of San Francisco–based Cogo Wolf Asset Management, an investment manager for wealthy individuals. He predicts that investors could withdraw as much as $500 billion from funds that tanked this summer.

Due to their limited disclosure and complex strategies, hedge funds may never be an appropriate option for the average investor — participation is generally restricted to those with high net worth who can afford the $1 million minimum investment typically required by fund managers. "It's a professional's market," says Thomas Whelan, chief executive of Greenwich Alternative Investments, which operates a fund of hedge funds. "You need to be able to research and understand what the funds do and then monitor them."

Still, no one's suggesting the hedge-fund industry will start to shrivel until it is once again the size of a cottage industry. According to HFR's composite index, hedge funds since 1990 have produced an average annual return of 13.94% (after fees) compared with 10.9% for the S&P 500 — and they delivered that higher return with half the volatility of the S&P 500. If similar results are maintained, the industry will continue to attract billions of dollars from institutional investors. Even during the subprime turmoil, Read of CalPERS said it never crossed his mind to write the industry off. "We definitely did not see it as a time to leave hedge funds," he says. Maybe now, if hedgies can just clean up their acts a little, they can put their summer slump completely behind them.

• William Boston