Despite their name, hedge funds may actually have little to do with "hedging."
Basically they are funds for a limited number of investors with a large amount of money to invest -- wealthy individuals, or big institutions like pension funds.
They also typically have active fund managers who try to achieve high returns regardless of which way the markets move. They are largely unregulated, and many are offshore for tax reasons as well as to avoid certain investment restrictions.
Keith Cuthbertson, a professor of finance at CASS business school in London, likens them to the wealthiest gamblers who bet large amounts at casinos.
"They're like the members of the high-roller suite at Las Vegas. Whereas the rest of us like mutual funds are gambling nickels on the fruit machine, these guys are gambling not only their own money but more importantly money they've borrowed from banks, which is called leverage," Cuthbertson says. "And that's where the danger comes with them."Short-Selling
Much of the criticism aimed at hedge funds has focused on "short-selling" -- basically betting against a stock. It involves borrowing shares and selling them in the hope they can then be bought back at a lower price.
This has been highly profitable -- the Paulson hedge fund is reported to have made some $430 million since September by short-selling shares in two British banks, Lloyds and HBOS.
Regulators in Britain and the United States at that time imposed temporary bans on short-selling of financial companies.
The short-selling led to charges that the funds were undermining financial stability -- claims the hedge fund bosses have denied.
Paul Marshall, co-founder of Marshall Wace, one of the hedge fund executives, was quizzed in January by a U.K. parliamentary committee looking into the banking crisis.
"The industry is not sitting there making vast fortunes at the expense of the British public," Marshall said. "Somebody said to me yesterday that to blame hedge funds was like blaming passengers for a bus crash."Bad Year
Marshall said hedge funds were themselves suffering.
The industry last year had its worst year in two decades. More than 900 hedge funds went out of business and some 20,000 jobs are expected to be cut worldwide this year.
Neil Mackinnon, an economist with ECU group in London, says aiming at the funds is to shoot at the wrong target.
"Hedge funds have come in for a lot of bad press; I think undeservedly so," Mackinnon says. "The real problems have been probably with the banks, actually, in that we've had a situation where many of the leading banks in the U.K., the U.S., and Europe have behaved recklessly."
Hedge funds say a better way to prevent risks would be to focus on the banks that lend to them and perhaps impose limits on lending.
Still, amid the worst financial crisis in decades, momentum is building toward greater regulation of hedge funds as well as other players in the financial system, like credit rating agencies
Last month, Jean-Claude Trichet, head of the European Central Bank, said the crisis was a "clear call" for extending regulation to all "systemically important institutions," particularly hedge funds and credit rating agencies
British Prime Minister Gordon Brown last week said "tax havens and the shadow banking system"" had to be brought "into the regulatory net" -- seen as a reference to hedge funds.Oversight 'Inevitable'
The European internal markets commissioner, Charlie McCreevy, said closer, direct regulatory oversight of hedge funds was "inevitable."
In the United States, Obama administration officials and lawmakers are considering how to boost oversight of hedge funds as part of a broader revision of financial regulation.
And the International Monetary Fund (IMF) has called for large funds whose failure would pose a risk to the global financial system to be regulated.
Outlining this proposal on March 6, the IMF's Jaime Caruana said this would apply to hedge funds as well as other entities engaging in similar investment strategies.
"It would happen whether it is an insurance company, such as AIG, or if it is a hedge fund, or if it is a bank," Caruana said. "It is not important what is the legal structure. The important thing is that they are engaged in a systemic activity that creates size and interaction and therefore it requires some capital requirements or some prudential [controls.]"
To be sure, there's still a way to go to reach consensus, with Europeans appearing more keen on greater regulation of hedge funds than Washington.
It looks likely to be the subject of discussion at the upcoming G20 meeting in London early next month.
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