When the ratings agencies downgraded General Motors debt to junk status in early May, a chill shot through the $1 trillion hedge fund industry. How many of these secretive investment pools for the rich and sophisticated would be caught on the wrong side of a GM bond bet? Could trouble with hedge funds ripple through the stock and bond markets, ultimately hurting ordinary people by undermining pensions and mutual funds?
It was hard to forget the 1998 collapse of the Long-Term Capital Management hedge fund. That crisis had so threatened to trigger a cascade of bond selling that the Federal Reserve jumped off the sidelines to broker a $3.6 billion bailout to keep the financial markets safe.
In the end, the GM bond bomb was a dud. Hedge funds were not as exposed as many had thought. And, as luck would have it, a stock market rally helped hedge funds eke out small gains for the month. But the scare did help fuel the growing debate about hedge funds. Are they a benefit to the financial markets, or a menace? Should they be allowed to continue operating in their free-wheeling style, or should they be reined in by new requirements, such as a Securities and Exchange Commission plan to make them register?
"Originally, I was opposed to the requirement that they be registered as investment advisors," says Marshall E. Blume, professor of financial management and finance at Wharton. "But I'm not so opposed anymore. I think there are some shenanigans going on, particularly with respect to the pricing of the assets that they hold. Some of these are really exotic [securities] for which there is no market. And there are incentives for the managers to make a lot of money real quick."
According to Wharton finance professor Jeremy Siegel, there is a risk that many hedge funds making similar bets could suffer big losses all at once, damaging other investors.
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