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Hedge funds are enjoying it all, right now

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Hedge-fund managers sit in the investment world's sweet spot, though it may be getting late in the game.

Successful hedge-fund managers can earn untold riches employing investment strategies that range from buying common shares and influencing public companies' strategies to delving into the arcana of derivatives and the distressed debt market.

Many enjoy a compensation structure that calls for investors to hand over a management fee equal to 2 percent of assets plus 20 percent of investment profits. And if the returns outpace more traditional investments, those forking over the fees will not complain.

On top of all that, regulators are falling over each other this week to sing the praises of these private pools of investment capital. There is a unanimous call for hands off any further regulation. At a Senate Banking subcommittee hearing Tuesday and elsewhere, there was homage by regulators and others to the public virtues of hedge funds.

There is no desire for more regulation at the Treasury, Federal Reserve or at the Securities and Exchange Commission, though some wrongly insist the SEC's mandatory hedge-fund advisor-registration rule is in itself overly oppressive regulation.

The upshot is hedge-fund managers can make lots of money without the distracting fanfare attendant to public-company chief executive compensation and receive hosannas, too.

Hedge funds provide liquidity, especially in opaque markets. They help price discovery and contribute to a narrowing of price spreads. They help distribute risk. All true.

But they also bring risks, and not just to their sophisticated investors. People hark back to 1998, when the hedge fund Long-Term Capital Management took on too much debt to finance bets that went sour. Its collapse threatened market stability, and the Federal Reserve had to step in to broker a private sector bailout.

A hedge fund teetering after taking on too much leverage is still a risk. Their central role in some derivatives markets that few understand is another one.

But the sheer size and importance of hedge funds argue against any regulation of trading strategies, leverage limits or other controls, even if there was the desire in some quarter to do so. The implementation of such rules in themselves could trigger the systemic issues regulators fear.

Fundamentally, further traditional regulation of hedge funds, especially any limits on trading activities, isn't warranted. Even if there was the desire to regulate, it's too late. It could have been done without great disruption when hedge funds were a much smaller part of the investment world. Not now.

Just consider some of the numbers bandied about in prepared testimony for the Tuesday Senate hearing. There are 9,000 hedge funds, maybe 10,000. They manage $1 trillion in assets; maybe it's $1.2 trillion.

"Some reports suggest that hedge funds account for between one-third or one-half of the daily volume on the New York and London stock exchanges," Randal K. Quarles, Treasury undersecretary for domestic finance, said in testimony. "Hedge funds contribute even more significantly to marketplace liquidity in less traditional markets. For example, hedge funds represent the overwhelming majority of trading volume in distressed debt markets, the convertible bond markets and the exchange-traded fund markets."

There is a logical case that market discipline will take care of hedge funds, although markets don't always work logically, at least not in the short term.

At some point, the market-discipline case goes, there will be a hedge-fund shakeout and maybe even enough competition to reduce fees.

It will be harder to earn "alpha" - returns above and beyond underlying market moves - and to justify the high fees, simply because there are so many more hedge funds trying to do it. That concentration of funds into certain areas and certain trades when a sector gets "hot" is in itself a systemic risk.

Also, as Quarles said, the broader investor base now diving into hedge funds, including public pension funds, will require hedge funds to be more transparent.

"Thus, the hedge-fund market has become much more 'institutionalized' as it has grown and evolved," Quarles said in prepared testimony.

If hedge funds become more like other investment vehicles, they are less likely to produce outsized returns. Down go the fees, but also down goes the systemic risk they present.

Lipschutz is vice president and managing editor of Dow Jones Newswires.

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