The hedge fund industry has a long history of avoiding tougher regulation. But as the Obama administration and Congress look for ways to avoid another financial meltdown, that history may soon come to an end.

Although it is not clear that hedge funds actually played much of a role in the current crisis, the industry’s sagging performance, combined with investors’ and regulators’ heightened demand for transparency, will likely cause big changes in the way these secretive investment pools operate, suggest several Wharton faculty members.

Worries about hedge funds are likely to escalate after The Wall Street Journal reported on March 18 that the now-notorious insurance giant AIG might use taxpayers’ money to make good on hedge funds’ bets that the housing market would fall. At the same time that the government is struggling to revive housing, it could spend billions rewarding hedge funds that profit from the housing decline, the paper said.

Critics have long wanted a regulatory crack-down on hedge funds, arguing that regulators, investors and the public at large know too little about how this industry influences the financial markets. But the industry has staved off regulatory pushes, the most serious of which was a 2005 Securities and Exchange Commission proposal to require the funds to register with the agency and submit to some scrutiny. The industry challenged the move, and in 2006 a federal court ruled that the SEC did not have that authority.

Now the push for regulation is gathering momentum. A bill introduced on January 29 by Senators Carl Levin, a Michigan Democrat, and Charles E. Grassley, a Republican from Iowa, would give the SEC authority to regulate hedge funds. Grassley argues that the political mood has changed since two years earlier, when he had introduced a similar bill that went nowhere.

Obama Administration officials also are pushing for tougher regulation, though how tough is still to be determined. According to news reports earlier this week, the administration’s broader plan for tighter regulation of the finance industry would include assigning greater oversight of hedge funds to the Federal Reserve. Stricter rules might require the funds to make public disclosures. Conceivably, tough rules could even limit hedge funds’ ability to borrow money to supercharge bets, or even curb some high-risk investments. The guiding principal will likely be to assure that a fund’s activities can hurt only its investors, not innocent bystanders. And it seems apparent that any regulation will come in stages, with the initial disclosure requirements leading to new rules as hazards are detected.

The 10,000 funds control about $1.5 trillion in assets, according to industry estimates. Hedge funds grew dramatically over the past two decades as investors sought market-beating returns, but now hundreds of money-losing funds have shut down and investors are clamoring to get their money back from many others. “The hedge fund industry is really swooning at this point,” says Thomas Donaldson, professor of legal studies and business ethics at Wharton. “We’re watching an industry whose bubble has popped.”

“We will see a major shift in regulation in the next year or so,” adds Wharton finance professor Richard Marston, referring to oversight of the entire financial industry, including hedge funds. “I don’t really care if the rich in Palm Beach are fleeced…. I care whether businesses in Philadelphia suffer because hedge funds have set off a panic in financial markets. Hedge funds didn’t [do that] this time. The banks did it. But next time, it may be the hedge funds.”

The average hedge fund lost nearly 20% in 2008. The glass-is-half-full camp notes this is only half the loss of the broad U.S. stock market. Still, it is upsetting to investors who recall the original goal expressed by hedge funds: to make money even when the broad markets fell. It was only the second year of losses on record; the first was a mere 1.45% loss in 2002.

Wharton finance professor Marshal E. Blume notes that because many hedge funds have shut down in the past year or two after being virtually wiped out, performance results covering only the survivors give a better-than-deserved picture. According to one study, about 700 funds liquidated in the first three quarters of 2008, a 70% increase from the year before. Some projections say the damage may have grown to 1,000 funds by the end of the year — about 10% of the industry. “There’s a lot of post-selection bias in the returns on hedge funds,” Blume says. “The hedge funds that go bust aren’t in those [performance] numbers.”

Role of ‘Policy Blunders’

Some of the hedge fund industry’s 2008 losses must, in fairness, be attributed to federal “policy blunders” in response to the banking crisis, says Wharton finance professor Richard J. Herring. He includes among those the decision last September to let financial services giant Lehman Brothers fail, sparking fear of mushrooming losses that depressed securities prices. Hedge funds were also hurt, he notes, by a ban last fall on short sales — bets on market declines that are key to many hedge funds’ investment strategies. “With the ban on short selling, the liquidity in several markets simply dried up.”

Although hedge funds may not be holding the smoking gun in the current crisis, many experts have worried for years that these pools could trigger a worldwide meltdown. The first alarm came in 1998 with the collapse of the Connecticut hedge fund Long-Term Capital Management, which had made complex bets on bond prices. To avert a financial tsunami, the Federal Reserve organized a group of major banks to take over LTCM’s assets.

“They weren’t altruists,” Marston says of the rescuing banks. “They were saving their own skin. That’s the fundamental case for oversight of hedge funds.”

Though current law does not require hedge funds to register with the SEC, many do anyway, because their institutional investors require it. Registered firms are believed to represent about 70% of hedge fund assets. Because they are open only to wealthy people and institutional investors, hedge funds have long been exempt from the kind of close regulation and public disclosure requirement imposed on mutual funds, exchange-traded funds, annuities and other investments open to everyone. And hedge funds have wider investment options, using short sales, leverage and bets on commodities and derivatives that many other investment pools are not allowed to use.

The theory is that hedge funds are limited to investors who can afford big risks. “I don’t think there should be any regulation preventing informed investors from losing money,” says Blume.

But the current financial crisis has put a spotlight on systemic risk, when the entire financial system is shaken by the activities of a small group of players, he notes. In today’s fast-moving markets, everything is connected to everything else. “The concern is that large pools of capital can contribute to systemic risk and systemic downturns. And that’s a valid concern…. Hedge funds have a large amount of money.”

If hedge funds’ bets can roil the markets, they can hurt innocent bystanders. Marston notes that university endowments and pension plans have become heavy hedge fund investors, providing another way for hedge fund failures to harm ordinary people. He cited one study showing that the average U.S. university had allocated 15% of its investment portfolio to “alternative investments,” which includes hedge funds and other pools that can be especially risky.

While there’s little doubt that hedge funds can be risky for investors, there is not much evidence they are the central villains in the current financial crisis, according to Wharton adjunct finance professor Christopher C. Geczy. “It is not clearly the case that hedge funds caused this crisis, which I think is the underlying populist sentiment,” he says.

Marston and Blume agree. “I don’t think the hedge funds were the cause of this current mess,” Blume notes, blaming instead government pressure to boost home ownership, which encouraged loans to home buyers with poor credit. Those loans were bundled into securities sold to investors worldwide, and prices for those securities collapsed when homeowners started falling behind on monthly payments at faster and faster rates. “The hedge funds just bought some of this stuff,” he says, “If the hedge funds lose money, that’s okay. No problem. It’s when the banks lose money that we have a problem.”

Much more blame for the financial meltdown belongs to the investment banks, Marston suggests. Unsatisfied with profits on traditional activities like mergers and acquisitions and securities underwriting, investment banks in recent years acted as if they themselves were hedge funds, making complex, leveraged bets in their own accounts, he says.

It might have been useful for regulators to have had more insight into the positions amassed by hedge funds, Blume adds, but the regulators did know that the banks were creating and selling structured products based on mortgages and other risky loans. “If they’d had more information about the hedge funds, would anything be different? Probably not.” The current regulatory structure does not address systemic risk very well, Blume notes, largely because the SEC, other government agencies and the securities industry’s own regulatory bodies, have traditionally focused on protecting individual investors, not looking at how the financial markets are functioning as a whole.

“Bringing hedge funds under this rubric will not help with systemic risk at all, because the SEC does not worry about systemic risk,” Blume says. “Here’s where we’re getting into new territory. By definition, if you are worried about systemic risk, you have to assign such concerns to one organization, and we don’t have that one organization right now. And, more generally, you have to do it worldwide. The U.S. is very reluctant to give up any sovereignty to foreign bodies…. Having said that, the current structure is inadequate. Where we go, I’m not sure.”

Various ideas are under discussion in Washington, from simply boosting authority of existing regulators to giving the Federal Reserve a kind of umbrella power over regulatory matters. There’s even talk of creating some new “superagency.” Rep. Barney Frank, a Massachusetts Democrat who chairs the House Financial Services Committee, wants the Fed to be assigned responsibility for protecting the stability of the financial system, with new powers to gather information from hedge funds, insurers, investment banks and other players. The Obama administration reportedly wants to be able to show real progress on this front at the April meeting of the Group of 20 finance ministers. Administration officials have embraced recommendations for tighter regulation in a report last year by an international committee led by Paul A. Volker, a former Fed chairman who now is a top Obama economic advisor.

The Madoff Effect

Even without new regulation, the industry is likely to change. Indeed, it is changing already: To keep investors, many funds have trimmed their fees from the standard 2% of assets managed and 20% of profits, Donaldson notes. “More people are talking — as Warren Buffett has always talked — about how the fees these funds charge are horrendous. We are really seeing fees coming down…. There have been a couple of funds that have waived the 20% part. Some have dropped the fees [on assets managed] from 2% to 1%.”

Funds are also under pressure from investors to loosen rules restricting withdrawals. Many funds actually tightened the rules — closing the “gate” — after the financial crisis spurred redemptions. There is “anger among investors who have seen the gate close on their investments,” Marston says. “Preventing investors from redeeming their assets when many are desperate for cash will permanently alienate some of them.” Allowing easy redemptions, however, creates problems as well. The funds can hemorrhage, making it hard, and in some cases impossible, to engage in complex investment strategies that require a long-term commitment.

Finally, there is the matter of just what those investing strategies are. Traditionally, hedge funds have offered investors only the vaguest of descriptions, arguing they must keep trading schemes secret to maintain their edge. “That argument, as strong as it is, is giving way slowly to at least a careful release of information, especially to the investors themselves, to give investors more confidence,” Donaldson says.

The drive for greater transparency is spurred by “the Madoff Effect” — heightened suspicions after the $50 billion Bernard Madoff Ponzi scheme came to light late last year. Although Madoff’s operation was not a hedge fund, it employed hedge-fund-style secrecy, and he did manage money for funds of funds, a hedge fund subset. Now, many hedge fund investors want to know more about how their money is used and who actually has possession of securities supposedly in the fund, Donaldson says. “I do think some added transparency with the SEC and other regulators — and options to go in and hunt down the devils if we think they are afoot in the fund — makes good sense.” But hedge funds’ investing options are so wide-ranging it will be difficult to regulate them very effectively, he warns.

Clearly, these are trying times for hedge funds. But not many experts think the industry will disappear. Investors will always be lured by promises of outsized gains, and hedge funds are free to employ strategies that mutual funds and other investment pools cannot. “I think [hedge funds] are going to be evaluated more carefully by investors,” Blume says, “but I don’t think the industry’s going to fade away.”