Remember John Meriwether? He was the legendary trader who left Salomon Brothers to open Long Term Capital Management, an equally legendary hedge fund, and in the process simply moved from one scandal – at Salomon it was the purchase of US Treasury bonds to another. This man exuded so much confidence at one point he even suggested that his activities make the markets more efficient. 

Fast forward to John Mack. The chairman and chief executive of Morgan Stanley and former chairman of Pequot Capital Management, the hedge fund with $7 billion in assets under management is described in more than one circle as a stand-up guy. While this amount under management is far less than the estimated $200 billion that LTCM managed, it still make Pequot among the largest hedge funds.

LTCM was once held in the same high regard as Pequot based almost solely on the reputation of its manager. Wealthy investors are drawn to this kind of celebrity in the hopes that they will not only grow their money but to do so with someone who shares their temperament for risk and reward. Mutual fund investors tend to gravitate towards low fees and performance while hedge fund investors are interested, especially at the minimum one million dollar initiation fee, in who the manager is.

The lure of this kind of confidence became so infectious that Myron Scholes and Robert Merton, 1997 Nobel Prize winners for economics for their work on derivatives and who were also key researchers behind the science of risk invested in LTCM. They were not alone. Along with chairmen of Merrill Lynch and Paine Webber, and as one report recalled, “a dazzling array of professors of finance, young doctors of mathematics and physics and other rocket scientists" all believed in Mr. Meriwether’s ability to generate double digit returns. And for many years, he did.

Even after LTCM took its 2% "administrative expenses" and 25% of the fund’s profits, it posted returns of 42.8% in 1995, 40.8% in 1996, and 17.1% in 1997 (which if you will recall was the year of the Asian crisis). Investors were thrilled and the fund became legendary. 

Under a veil of absolute secrecy, investors in LTCM were required to pony up $10 million, which was frozen for 3 years. Investors asking questions were shown the door. But by September of the following year, after mistakenly gambling on a convergence in interest rates, LTCM found itself on the verge of bankruptcy.

Hedge funds are important to all investors though you might not have the million plus to join the “club”. They are primary vehicle for private and public pension funds and retirement accounts. And because that and of the possibility of economic repercussions, the Fed stepped in to stave off the complete collapse of the fund.

Since 2004, the S.E.C. has sought to regulate this industry and has been repeatedly rebuked by the D.C. Court of Appeals. Hedge funds fall neatly under two existing regulations: the Investment Advisers Act of 1940 which requires broker registration when more than 15 clients are involved but if the fund has less than one hundred investors, the demanding Investment Company Act of 1940, regulation is not required either. The S.E.C., with the criticisms of Wall Street and without the help of the courts or Congress, has instead sought to redefine the word client in order to broaden their regulatory powers.

Gary Aguirre, the attorney whose employer, the Security and Exchange Commission would not allow him to conduct an interview with Mr. Mack and his connection to Pequot. They subsequently dismissed him. He in turn wrote an eighteen page letter to the Congress outlining his allegations that Mr. Mack conducted his fund in an illegal manner. He spoke before the Senate on Wednesday.

Hedge funds, which tend to fly well below of the regulatory oversight of the S.E.C. still present problems for investors in ways Mr. Aguirre suggests that influence company stock prices.

Interest, or lack of it, in the information stemming from Aguirre’s allegation is applauded by capitalists on Wall Street as exactly the kind free advertisement the under-regulated hedge fund industry needs to continue to draw investors to the fold. The question remains: Should the S.E.C. be given the power to regulate these private funds, whose manipulation of the markets could have an affect on investors far removed from their secretive pursuits?

Whether they should have such power hinges on the appeal these funds have to the ordinary investor. Deemed as above the normal investment world, hedge funds use a much wider variety of tools to try to achieve the outsized gains well-heeled investors seek.

The belief that the collapse of these types of funds, which happens on a far more regular basis than the much more regulated mutual fund industry, would create market mayhem is only partially true. Apart from the fact that it is estimated that hedge funds do 30% of the daily trading, they attract more than just wealthy independent investors. They also attract a large pool of institutional investors that tend to represent the aforementioned pensions.

Two things need to change in order to satisfy the Commission’s concerns. If hedge funds could protect their investors from a stampede of withdrawals from nervous investors and make their lines of credit with Wall Street more transparent, many believe the S.E.C. might back off its efforts to bring the industry under regulation.

As hedge funds have increasingly ventured into more riskier investments, the ability of investors to exit such funds have been compromised. And with that, the possibility that the ripple effect could extend farther than previously thought. Perhaps Mr. Aguirre sensed this when he began his investigation.

The ripple could begin almost anywhere. Currently, Wall Street offers extended lines of credit to hedge funds and those lines are essentially backed by banks who are also dangerously leveraged. Hedge funds have used these lines recently to extend themselves into newer types of debt. Here is where the real danger lies.

Using structured products involving debt of numerous companies rather than seeking high yields in single corporate offerings, hedge funds have made themselves vulnerable to downgrades and investment mandates. Those downgrades would come from credit agencies while the investment mandates would be generated by the institutional investor such as insurance companies or pension funds. The squeeze from either or both of those sources would be repercussive throughout the markets.

Should a hedge fund fail or look as if it might, the Treasury and Federal Reserve Bank are the government agencies charged with the recovery efforts. S.E.C. on the other hand, could go much farther in protecting investors – before the fact.

© 2006 Paul Petillo
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