A hallmark of Wall Street lore dating to the Roaring Twenties and the Great Crash has been that the rich and influential trade secrets and make the most from the markets. And if they get burned, so can the rest of us.
The Securities and Exchange Commission, the nation's top markets regulator, was formed after the crash to level the playing field and protect all investors. But now, more than 70 years later, market observers are worried that the secret moneymaker du jour for the wealthy - hedge funds - could cause history to repeat itself.
Hedge funds, or lightly regulated investment pools, manage more than $1 trillion, double the amount just five years ago. They are believed to be responsible for as much as half of the trading volume on the New York Stock Exchange each day.
Last year alone, an estimated 2,073 new hedge funds started up, or about one every 60 minutes during business hours.
The newfound power and reach of hedge funds, and a growing number of scandals, have spurred calls for more regulation. The sheer magnitude of the industry has fostered fears the funds could bring entire markets down. And lackluster returns at some funds, perhaps no better than what an investor would get from a money market fund, have prompted critics to question whether they're worth the massive fees they charge.
SEC Chairman Christopher Cox said last week that he plans to push for new emergency regulation of the high-risk funds after a court threw out a previous attempt to increase oversight.
The long-insular and mysterious realm of hedge funds is indeed losing some of its cover.
Most hedge fund managers closely guard their strategies and take at least 20 percent of the profits. In a global market with deep pockets and complex computer trading systems, they take advantage of anomalies and mispricings, sometimes swooping in with rapid-fire, short-term bets.
A hedge fund is simply a pool of money raised from a number of investors and managed by an individual or group to produce the highest possible return. Unlike conventional mutual funds, hedge managers are not required to make public information on their investments, profits or losses.
Hedge funds bet on almost anything, from currencies and commodities to interest rates and foreign economies. And they are designed to make money, or at least preserve capital, whether markets rise or fall. They use leverage to magnify gains and sell short when they expect markets to be down, essentially betting that prices will fall.
In the opening pages of Hedgehogging, an insider's look into the heady world of hedge funds published earlier this year, investment veterans gather for a dinner and a glass of brandy to gossip about their business and moan about the competition.
They discuss whether too many hedge funds could mean less "alpha" for them, using the industry code for above-market returns that managers get paid handsomely to deliver. One fund manager glumly predicts the current golden age for hedge funds might soon end with a "bang." The scene reveals that some Wall Street pros are privately worried even as the hedge fund industry publicly dismisses negative hype.
Hedgehogging author Barton Biggs, a former Morgan Stanley research head who runs the Traxis hedge fund in New York, contends that hedge funds are no more risky than other investment accounts. While Biggs describes some hedge fund managers as "bizarre characters," he also calls them "brilliant" and "brave."
In keeping with the anonymity that hedge funds covet, Biggs doesn't name many of the people in his book "to protect and to avoid offending or embarrassing the innocent and unwary," he said. To further obfuscate, Biggs said he altered places and dates, and used composite portraits.
For decades hedge funds have been available only to so-called accredited investors who meet net-worth requirements, and many funds required investors to put up hundreds of thousands of dollars. The reasoning: Wealthy investors are presumed to be sophisticated enough to understand the risks unique to hedge funds, or at least to have enough money to hire someone who does.
But who defines "wealthy"?
In this case, the Securities and Exchange Commission defined accredited investors 25 years ago as having a net worth of at least $1 million, or earning more than $200,000 a year, or $300,000 with a spouse.
After years of inflation, and a housing boom that made even some condos worth millions of dollars, however, many of today's middle-class families are wealthy by that definition. Perhaps more important, the idea of limiting hedge-fund investing to the privileged hasn't washed in a nation that prides itself on egalitarianism - and on everyone having the same shot at making a buck.
As a result, the financial business has devised ways in recent years to let in the little, or rather littler, guy or gal.
Firms that manage funds of hedge funds now offer investors a chance at the action with minimum investments as low as $25,000. The firms offer an extra layer of scrutiny - and fees - by picking out hedge fund managers for investors. Still, there are often barriers to those with more meager means.
Baltimore's Legg Mason Inc. acquired the Permal Group fund-of-funds shop last year, but it only allows accredited investors in with a minimum of $1 million. Mercantile Bankshares Corp. of Baltimore, which runs a fund of hedge funds, offers a lower entry investment of $75,000, though individuals must have a net worth of at least $1.5 million. Mercantile announced this month that it would open the fund, which had been available only to clients of its wealth management division, to outside investors.
Mutual funds also joined in. Companies such as Rydex Investments in Rockville and ProFunds Advisors in Bethesda have launched mutual funds, which anyone can invest in, that mimic hedgehog strategies in what Lipper Inc. analyst Jeff Tjornehoj calls "the poor man's hedge fund." Rydex offers two funds advertised as similar to hedge funds, while ProFunds frequently uses leverage, or borrowed funds to generate a greater return, as many hedge funds do.
Institutional investors also have jumped into hedge funds. University endowments are big players, probably clued into the hedge-fund game by affluent board members, followed by pension funds that oversee worker retirement savings and gravitated to hedge funds as a way to protect investments through diversification.
Just how well hedge funds are doing is impossible to pinpoint.
The funds aren't required to disclose investment returns. Private databases only capture portions of the hedge fund universe and show wildly different results. The Standard & Poor's hedge fund index, for instance, posted a 2.4 percent gain last year, falling short of the S&P; 500 stock index's 3 percent. A hedge fund index from Credit Suisse/Tremont, in contrast, returned 7.6 percent. According to Hedge Fund Research, the funds returned 9.4 percent.
Some critics contend that hedge funds are suffering from a Lake Wobegon effect, in which everyone claims to be above average.
Larry Swedroe, research director at Buckingham Asset Management in St. Louis and author of What Wall Street Doesn't Want You to Know, said existing data about hedge funds are biased. In particular, he suspects only the good ones are releasing their numbers. In addition, he said high fees eat away at returns and that investors have been getting returns akin to those on Treasury bonds or money market accounts - while taking on more risk.
The irony is that popularity and democratization might cause hedge funds to suffer. Some say it's a mathematical certainty.
As more money flows into certain fund strategies, it becomes more difficult to earn a superior return. Take an arbitrage tactic in which a hedge fund identifies a security that's fetching a higher price on the Chicago Mercantile Exchange than the New York Stock Exchange. When that fund starts buying in New York and selling in Chicago, the price discrepancy shrinks, until it's gone. If more than one fund sees the same opportunity, it shrinks faster.
But Jeff Joseph, managing director of the alternative investment group at Rydex, said it's "naive" to think that markets won't grow, creating more opportunities for hedge funds. The trick for investors, he said, is the same as if they were investing in traditional mutual funds: "You have to separate the wheat from the chaff. Only a handful are worthy of holding investor money."
And stories of striking it rich continue to circulate. As evidence of colossal profit-taking, hedge fund superstars T. Boone Pickens and Stevie Cohen made an estimated $1.5 billion and $1 billion, respectively, last year, according to Trader Monthly.
Even the harshest hedge-fund critics credit them with making markets more efficient. The very fact that the funds are active buyers and sellers increases the chances for other investors to either offload unwanted securities or snap up ones they want. Hedge funds are also prolific buyers of derivatives, which are issued by financial institutions to spread out their own risk, thereby helping to keep the entire financial system sound.
But much isn't known about the activities of hedge funds. Like secret agents, managers say they need privacy to survive. They have invested enormous time and money in hiring top MBAs, mathematicians and physicists and in building technologies that run complicated statistical models. If they were forced to open their books, hedgehogs argue, copycats would rush in and they would lose their competitive edge.
The SEC tried to get hedge funds to register with the agency, which would have subjected them to random examinations by regulators. But the industry fought back, and last month a federal appeals court overturned the regulation, sending it back to the agency for review. About 2,450 hedge fund advisers already had registered before the ruling.
Susan Wyderko, then a high-ranking official at the SEC, had said that the agency planned to focus examinations on the potential for theft by hedge fund managers, who typically have access to fund assets. Other possible trouble spots, she said, are the policies used to value assets in light of cases in which managers lied to hide losses, as well as side arrangements that could give rise to conflicts of interest.
The CFA Centre for Financial Market Integrity reluctantly backed the SEC rule. Kurt Schacht, executive director, said the think tank would prefer an industry system of ethics and professional conduct over government intervention, but that hedge funds haven't coalesced around self-regulation, so an SEC rule seemed the only option.
"Investors are clamoring to get into these things; it's like a gold rush. Managers are clamoring to offer supply. And regulators are concerned," he said. "It would behoove everyone to step back and take a deep breath and ask what does this industry really need."
Hedge fund defenders say that speculation about shenanigans is overblown. Perrie Weiner, an attorney in Los Angeles who heads the hedge fund practice at DLA Piper Rudnick Gray Cary, said SEC registration would have been "overkill" and would have increased expenses that are passed on to investors.
"There haven't been enough instances of hedge fund failures to warrant that type of surveillance," he said. "There's nothing endemic or systemic going on in the hedge fund community."
Still, lawmakers on Capitol Hill have stepped up scrutiny of hedge funds in recent months. At a hearing last month, Attorney General Richard Blumenthal of Connecticut said the investment vehicles have fallen into a "regulatory black hole." Numerous hedge funds are run from Connecticut, and hedge-fund managers have snapped up Greenwich mansions, giving the town what could be called a "Great Gatsby" aura.
"The danger is perhaps heightened with hedge funds because they have amassed so much financial power - in the markets and elsewhere - with so little transparency or accountability," Blumenthal said.
At that same hearing, attorney Gary J. Aguirre warned of shadowy figures in the industry and of powerful interests protecting them. Aguirre claims he was fired last summer from the SEC after he tried to subpoena Morgan Stanley chief John Mack in an insider-trading investigation of hedge fund manager Pequot Capital Management. The agency and representatives for Mack and Pequot have dismissed his story.
Aguirre's assessment of the danger posed by hedge funds was even more pronounced than Blumenthal's, likening them to unregulated pools of money that were instrumental in the stock market crash of 1929.
"There is growing evidence that today's unregulated pools - hedge funds - have advanced and refined the practice of manipulating and cheating other market participants," he said.
Edwin Boyer of Asset Strategy Consultants in Baltimore said problems in hedge funds are surely inevitable. But he chalked that up to "human nature," which leads to wrongdoing in any industry. He said most hedge fund partners "have pretty high ethical standards; they've gone to fine schools; oftentimes they've worked at major brokerages."
James S. Riepe, a consultant at Baltimore mutual-fund company T. Rowe Price where he retired last year, said he has friends who manage hedge funds and believes it's a "legitimate" way to invest. Nonetheless, like Biggs' hedgehogs, he is nagged by worries.
"One has to step back and question when hedge funds have gone to more than $1 trillion in such a short time, and when you have new funds being formed literally daily," he said. "Why do all the other financial services have to be so transparent and hedge funds don't, particularly if they can affect the entire market?"