Any fallout from the recent losses suffered by a pair of hedge fundsthat came out on the wrong side of a bet on natural gas prices probablywon't include a ripple through the financial markets or a governmentrush toward more regulation.
More likely, the onslaught of moneythat's been poured into hedge funds over the past four years--roughlydoubling their assets to over $1 trillion, according to the Hedge FundsIndustry Association--may slow down a bit as investors take a breathand pay closer attention to their funds' strategies and their managers'styles.
"You've got to know your fund manager," says investmentadviser John Mauldin, who publishes a newsletter that tracks the hedgefund industry. "So many investors just look at past performance, whichis not a reason to buy a fund."
His comments come in the wake ofreports that Greenwich, Conn.-based Amaranth Advisors, a fund with anestimated $7.5 billion in assets, has lost 35% of its value this yearthanks mostly to a recent drop in natural gas prices. Amaranth'stroubles come on the heels of those of MotherRock, LP, an energytrading fund that has suffered big losses since June and plans to shutdown. Funds that trade energy have been through volatile times lately,with natural gas prices off 20% since the beginning of September andcrude oil down to $64 a barrel from $78 last month.
Industryexperts say hedge funds have been taking greater risks of late, tryingto chase the 15% to 20% returns of a few years ago, which have mostlydried up recently. The average hedge fund returned 8% last year,according to industry tracker Hennessee Group, in line with the averagemutual fund.
But in the investment world, the hedge funddepartment is where the big boys play. And the territory is generallyfilled with experienced people who appreciate the risks involved andwho know how to take their losses. A one-sided bet on natural gas orany other energy product is going to produce big gains orlosses--exactly what a hedge fund investor expects.
"Investorsare supposed to understand the risks, assuming they're properlyqualified," says attorney William Natbony, a senior partner in thefinancial services group of Katten, Muchin Rosenman in New York.
Anda failing fund isn't very unusual. About 5% of the estimated 7,500 to9,500 hedge funds fold every year, the Hennessee Group says, largelybecause impatient investors with a lot of choices don't offer much of agrace period to managers who bring home lackluster returns. Even a bigloss by a fund like Amaranth is unlikely to have much of a trickle downeffect, according to Natbony.
A 35% loss "still means that 65% of the assets are in place, so the fund is properly collateralized," he says.
Thefallout of the two funds may serve to bring back voices calling formore SEC regulation of the industry. Just yesterday, Rep. Mike Castle(R-Del.), spoke out in support of more transparency while calling for astudy to examine hedge funds' impact on the economy. But Mauldin saysthat regulation would produce little value, since any new rulesprobably wouldn't take direct aim at a fund's particular assets.
"Aregulator can tell them to play by the rules, but won't tell them whatthey can or cannot invest in," he says. Fraud cases in hedge funds, hesays, are pretty minimal compared with public companies, rendering morerules largely useless.