When the Lilliputians came upon the sleeping Gulliver, they didn't know if he was friendly or hostile, but he was so big it seemed prudent to tie him down. Should the 9,000 hedge funds -- the secretive investment pools controlling $1.4 trillion in assets -- be treated the same way?
The President's Working Group on Financial Markets doesn't think so. In a late-February report, the group, chaired by Treasury Secretary Henry M. Paulson, urged vigilance but concluded that new regulations are not needed. The freewheeling world of hedge funds and their cousins, private equity and venture capital, have for now escaped the tightened oversight imposed on publicly traded companies after Enron and WorldCom.
Was this the right decision? For the most part, it was, say several Wharton professors who have studied hedge funds and other so-called private pools of capital.
Private pools have a key role in providing market liquidity -- making sure anyone who wants to buy or sell a given instrument has someone to trade with -- these faculty say, adding that restricting private pools' activities or forcing them to disclose too much about their strategies would hurt liquidity and weaken the financial markets.
"These private pools may help keep markets from overshooting [when prices rise], and they may provide floors [when prices fall]," says Wharton finance professor Richard J. Herring. "It's very secretive," adds Wharton finance professor Richard Marston. "Even a fairly wealthy client won't necessarily find out about the hedge fund strategy." If regulators forced hedge funds to disclose their holdings, "that would be the end of some of these strategies," he predicts.
Inexperienced Managers: Exotic Investments
Still, the Wharton professors note that, because of their size and secrecy, private pools can create risks for the broad market that no one can perfectly gauge.
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