Target investor: worth at least $1 million. Trading strategy: sometimes so complex it takes a PhD in math to figure it out. Fees: high.
It's no wonder that hedge funds are seen as the investment toys of the rich.
But increasingly, these funds are touching the lives of all Americans - from the performance of their pension funds to the price they pay for a gallon of gasoline. While it's not clear how much they sway markets, it's undeniable that they've grown by leaps and bounds over the past several years.
That growth has now caught the eye of the US Securities and Exchange Commission in Washington. Late last month, a divided SEC voted to require hedge-fund advisers with more than $25 million of assets to register by February 2006. The idea is to discover and prevent fraud before it happens - and head off any potential meltdowns in world markets.
Hedge funds differ from mutual funds. Though their investment strategies vary enormously, they're often riskier. Managers look for "holes" or trends in various markets they can exploit, and thrive in volatile markets. If hedge fund managers don't do better than average for clients, they quickly go out of business. Their clients flee for greener fields.
Then there are the rewards. Since 1990, hedge funds have earned an average 11.9 percent a year, better than the 10.5 percent return of the Standard & Poor's 500 stock index or the 9.2 percent of the average stock mutual fund. Many hedge funds made money even during the recent stock market slump, though their average return this year has not been stellar so far.
Finally, there are the requirements. While a person may need $3,000 to invest in a mutual fund, investors in hedge funds generally must have assets of at least $1 million or have made more than $200,000 a year for two years.
Despite these barriers, the number of hedge funds has increased at least fivefold over the past decade to 8,800 globally. Their assets have risen 15-fold during the same period and may reach $1 trillion by the end of this year. Since they now account for about 40 percent of trading activity on US stock markets, perhaps as much as 70 percent on some days, they do sway stock prices. At issue is how much influence they really wield.
"They have extraordinary power to influence markets," says Paul Woolley, chairman of GMO Europe in London. His money-management firm, based in Boston, looks after $66 billion, of which some $4 billion is hedge-fund money.
In 1998, a huge hedge fund, Long-Term Capital Management, borrowed money and bet wrong on the direction of interest rates. Its size and perilous condition created such fears of a financial crisis that the Federal Reserve came to the rescue.
Mr. Woolley sees an additional peril besides the possibility of a fund going belly up. It arises from a polarization in the way money is invested in stocks. The great bulk of money is put into investments that track market indexes, such as the S&P 500, or into mutual funds that attempt to beat these indexes by at least a little bit. Their asset values tend to rise and fall with the market, and investors tend to stay put.
But hedge-fund managers are risk-takers, often attracted to their jobs by the prospect of getting rich quick. They generally take 20 percent of the profits of their clients.
Woolley worries that hedge funds, well-placed to spot and take advantage of the tendency of stocks to trend above or below a "fair" value, will pile their money into an individual stock or market sector, and thereby exaggerate swings in prices.
Such "momentum investing" may hurt index-style investors by destabilizing stock prices and damaging capital markets. "That could penalize everybody," he warns.
Hedge-fund money reportedly was one factor that has pushed crude oil prices above $55 a barrel in recent weeks.
Meanwhile, more and more pension funds are investing money through these largely unregulated vehicles. So do many charitable endowment funds, including those of churches. That's why some experts want more regulation. SEC Chairman William Donaldson hopes that by examining the filed papers of advisers, the commission can discover fraudulent funds before they cause real damage.
But registration will be of little value in detecting fraud, holds Fed Chairman Alan Greenspan. Usually it's revealed by customers or disaffected employees.
The two dissenting Republican commissioners argue that the SEC would have been wiser to focus its resources on such areas as mutual funds, where millions of people have their money invested.