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These new investors also demand details about who is managing their money. "What has been a wake-up call for them is that communication is very much a key part in being able to attract and retain this level of assets," says Rupert Allan, president of Tremont Capital Management, which creates and manages portfolios that invest in other hedge funds.
The intensity of interest from Washington has been another wake-up. Although individuals generally must have at least $1 million in total net worth to invest in a hedge fund, regulators and Congress are sharpening their focus on the largely unwatched vehicles as more run-of-the-mill people become involved through pensions. "Tens of millions of Americans may be unwittingly exposed," wrote the Senate Finance Committee's Charles Grassley last month in a letter to regulators. The Securities and Exchange Commission plans to raise the $1 million threshold for individual investors, and is also working on requiring hedge funds to register.
The concerns are twofold. The first is fraud, which was underscored last year when the principals of Bayou Management pleaded guilty to bilking investors of $450 million by telling some fairly brazen lies. Regulators are examining whether some hedge funds may be making illegal insider trades in certain situations, as when companies privately talk to their lenders.
There is also the worry that a big hedge fund (or funds) could melt down, as Amaranth Advisors did in September when it vaporized $6 billion in a week by making a bad bet on the future price of natural gas. Among the fund's investors was the $7.7 billion San Diego County pension fund, which was out nearly $90 million.
The broader concern is that an Amaranth-type event or series of events would ripple through the system, as in the case of 1998's implosion of Long-Term Capital Management, which zapped more than $4 billion in short order and required a federally engineered bailout to protect the worldwide economy.
Hedge funds play an important role in markets by providing liquidity and contributing to the collective wisdom that figures out prices for everything from companies to coffee futures. This function has only proved more important over the past 30 years, as the number and diversity of financial instruments have surged. But there's a dark side. Complexity and linkages across markets--tight coupling, in the language of systems analysts--make problems more likely to spread to other players, such as Wall Street banks, especially since hedge funds often leverage their investments, which magnifies gains. Or losses. "In most areas, risk goes down over time--airplanes are safer, GDP is more stable--but financial markets have gotten riskier," says Rick Bookstaber, a hedge-fund manager who is writing a book on the topic. "Financial engineering has actually created more risk by adding complexity." Since the summer, the Treasury Department has been meeting with regulators, investors and hedge-fund managers to study this sort of systemic risk.
The response from hedge funds is indicative of their new Establishment persona. They are hiring lobbyists and courting lawmakers--a far cry from the way hedgies dug in their heels in 2004 when the SEC first proposed they register basic information.