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Next scandal? Try hedge funds

This barely regulated business with more than $1.2-trillion in capital provides ample opportunity for abuse.

By HELEN HUNTLEY
Published May 27, 2006

With Enron's top executives convicted and most likely headed for prison, we hope we've put corporate accounting scandals behind us or at least on the back burner.

But it can't be long before something else claims the financial headlines. With so much money to be had and so many people who want to have it, the calm probably won't last long.

What could be the next scandal to roil the financial markets and capture the media's attention the way accounting high jinks did?

Try hedge funds.

There are other simmering issues that might reach the boiling point. For one, there's all that risky mortgage financing that put consumers into homes they won't be able to afford if interest rates rise. For another, there's the massive underfunding of corporate pension plans. Perhaps even the growing Wall Street fascination with executives who have profited mightily from back-dated stock options.

But for big-time, near-term crisis potential, nothing beats the hedge fund business.

If you think CEOs make too much money, consider James Simons, a hedge fund manager who made $1.5-billion last year, according to Alpha magazine, which follows the industry. He received a 5 percent management fee and 44 percent of his fund's profits. Oilman T. Boone Pickens Jr. came in second with a $1.4-billion take. The top 25 managers in the industry all made at least $130-million.

That's for one year's work.

You can be sure that money like that is attracting plenty of imitators, including some who just might not have their investors' interests at heart.

Hedge funds are simply pools of capital with great freedom to invest whenever and wherever the manager deems fit. Depending on the manager's preferred style, a fund might be betting that U.S. stocks will go up or down, trading foreign currencies, taking equity stakes in private businesses, or buying up shares in emerging markets.

There are now about 8,000 of these funds with more than $1.2-trillion in capital. Increasingly, they are attracting pension money and the funds of less sophisticated investors who like the idea of making a lot of money quickly, but may not be able to withstand seeing their savings evaporate if the manager makes too many bad bets.

"There's an opportunity for a lot of abuse in that area," said Clearwater financial planner Ray Ferrara at ProVise Management Group. "If there is a crisis, it could be very difficult on some people. Even sophisticated people like George Soros can lose a lot of money."

Hedge funds are barely regulated. Nobody is checking up on the managers and the accuracy of their reported returns. For the most part, investors have to rely on the managers to tell them what their investments are worth. With investments that don't trade regularly, such as equity stakes in private companies, valuations are subjective.

Furthermore, hedge funds are illiquid. Depending on the fund, investors may be locked in for a year or two, giving the manager freedom to make riskier bets. Given the lack of regulatory oversight, it's hard for everyday investors to sift between the good hedge funds and bad. All they really have to go on is the fund manager's reputation and record, but past results don't always translate into future rewards. The best path for the wary may be the same rule of thumb that applies to all investments: Don't concentrate too much of your money in any single fund.

Hedge funds have an outsized influence on the financial markets not only because of their burgeoning size, but because many of them make their bets with borrowed money, leveraging their capital and their impact. And when things don't go right, it's not just hedge fund investors who feel it. A lot of the selling in the U.S. stock market over the past two weeks was sparked by hedge funds invested in Saudi Arabia, said Jeffrey Saut, market strategist for Raymond James & Associates in St. Petersburg. He said the funds needed to raise cash, but their Saudi positions were illiquid, so they sold U.S. stocks instead.

"Maybe stability is here for a while, but if I had to guess, the next problem or cause approximate will be in some hedge fund," Saut said.

While some hedge funds make big money, others produce mediocre returns and still others crash and burn. Funds dissolve regularly, but the failure of a very large fund or the simultaneous failure of many smaller funds could put a strain on the financial system. In 1998, the Federal Reserve stepped in to organize a rescue of one fund, Long-Term Capital Management, but investors still lost several billion dollars.

Naturally, no one can say for sure where the next crisis will erupt. We may be wrong to assume that the accounting scandals are behind us. Greed hasn't gone out of style in the executive suite.

"I thought we were over this kind of stuff with Mike Milken junk bond king of the 1980s, and here we are 20 years later still doing it," Saut said. And, he pointed, out, the next big scandal might be something we aren't even thinking about. "They don't call them surprises because you expect them."

Helen Huntley can be reached at hhuntley@sptimes.com or (727) 893-8230.

[Last modified May 27, 2006, 06:37:51]