But the industry's success has been marred by the recent closure of some high-profile funds and the growing number of hedge-fund fraud cases.
As a result, the Securities and Exchange Commission, which regulates the mutual-fund industry, began investigating the virtually unregulated hedge-fund sector last year.
Tomorrow and Thursday, the SEC will hold public meetings in Washington to discuss whether hedge funds should come under more regulatory scrutiny. Should the funds and their managers be required to register with the SEC and disclose financial information? To that end, should hedge-fund investment strategies be monitored? Should companies be allowed to continue to sell both registered and unregistered investment vehicles?
Besides hedge-fund managers, panelists will include representatives from the accounting and financial services industries, and institutional investors, such as Yale Endowment and the nation's largest pension fund, the California Public Employees' Retirement System.
"There have been frequent reports of high returns of hedge funds that outperform registered investment companies," SEC Chairman William H. Donaldson said in testimony before the Senate Committee on Banking, Housing and Urban Affairs last month.
"But, just as frequently, these reports highlight possible areas of concern, such as potential conflicts of interest, questionable marketing techniques, valuation concerns, and market impact of hedge-fund strategies," Donaldson said.
Last year, the SEC took action against 12 hedge funds - more than twice the number of cases in each of the two previous years. Allegations included misappropriating or diverting investor funds to pay personal and business expenses, falsifying tax documents and statements to investors, and promising returns they could not achieve.
The first major hedge-fund scandal was in 1998, when Long-Term Capital Management L.P., a Connecticut-based fund that leveraged, or borrowed money, against the value of securities in its portfolio to speculate in high-risk trades in global markets. The strategy caused the company to lose $1.8 billion, and brought it to the brink of closure. The Federal Reserve, concerned that Long-Term Capital's troubles would depress world financial markets, organized a bailout of the hedge fund in the fall of 1998.
In January, New York-based Gotham Partners Management Co., which had $300 million in assets under management, closed its largest hedge funds because of losses on investments in golf courses.
The Investment Company Institute, an association of the mutual-fund industry in Washington, supports the SEC's decision to evaluate possible regulation of the hedge-fund industry.
In a letter to the SEC last month, ICI said: "It is very timely for the commission to consider whether this historical 'hands off' approach remains appropriate or should be modified in some fashion. This is because of the significant increase in the number of hedge funds, the number of entities sponsoring hedge funds and the number of individuals investing in or otherwise having exposure to hedge-fund investments."
Jeff Molitor, a principal at Vanguard Group Inc., the mutual-fund company in Malvern, put it this way:
"People are looking at hedge funds as the silver bullet for yesterday's market," he said. Vanguard does not administer hedge funds.
"Too many people are attracted to them. We think hedge funds can make sense for sophisticated investors who understand what risks they're taking," Molitor said. "People who blindly put money into something that seemed to have worked before might as well go to Atlantic City."
One local hedge-fund manager agreed that some regulation could be appropriate.
"The SEC is just trying to protect the public from putting money into something they don't understand," said Mark Schlarbaum, cofounder of Schlarbaum Capital, a $50 million hedge fund in Bala Cynwyd. "It's part of the maturation process for the industry."
Hedge funds may sound new, but they have been around since 1949. They are unregistered pools of private investments in stocks, bonds and other types of securities.
Unlike mutual funds, they are not required to disclose their asset allocations, investment strategies or fee structures to regulators. Typically, a hedge-fund manager charges a fee of 1 percent to 2 percent of the fund's assets, and can keep up to 20 percent of its annual return.
The original purpose of such a fund was to "hedge" one investment in case another investment declined in value. For instance, a hedge-fund manager might buy shares of ChevronTexaco Corp. and short-sell shares of Exxon Mobil Corp.
Besides leveraging, short-selling is another popular investment strategy. Fund managers take short positions on securities they think will decrease in value. Here's how it works: The manager borrows securities from a broker and immediately sells them on the market. The manager later repurchases these securities, ideally at a lower price than he sold them for, and returns them to the broker. The fund is then able to profit from a fall in a security's value.
Registered investment vehicles, such as mutual funds, are limited in their ability to use the same investment techniques as hedge funds. In general, mutual funds take long positions on securities, holding them for several years to wait out boom-and-bust cycles.
Edward Stavetsky, managing partner at Pembroke Capital Management Inc., a West Conshohocken investment advisory firm, said hedge funds provided more diversity to investors' portfolios.
"It doesn't make a whole lot of sense to have an investment strategy for clients that is only long," said Stavetsky, who expects to launch a hedge fund in June.
"When you have an extended down market, you're only losing. I don't believe in relative gain - you're down 20 percent, but the S&P is down 30 percent."
In the past, only wealthy investors - those with salaries of at least $200,000 annually and net worth of upward of $1 million - could meet the minimum investment of $250,000 in a hedge fund.
But that has changed within the last year, as so-called "funds of hedge funds" have registered with the SEC and require smaller minimum investments of $25,000, in some instances. These funds invest in a wide variety of hedge funds. The theory is that small investments in many hedge funds should reduce an investor's exposure to risk.
Some individual investors, university and charitable endowments, and state pension plans have started funneling a percentage of their money into funds of hedge funds, trying to boost their investment returns after three bad years in the stock market.
Last summer, the Pennsylvania State Employees' Retirement System decided to invest 10 percent, or $2.4 billion, of its $24 billion portfolio in funds of hedge funds.
"With the market turmoil of the last two and a half to three years, we're always searching for some absolute return strategy," PSERS Chairman Nicholas J. Maiale said.
"We felt that, if we're going to do it, let's do it early and jump in with both feet. So far, the returns are marginal but above what the market was doing through 2002."
Still, Maiale said regulation of hedge funds was a good idea. "I think there ought to be more and more transparency," he said.
Hedge-fund manager Schlarbaum said regulators would need to walk a fine line between overseeing the industry and overhauling it.
"It's important that the SEC regulate the [fund] manager but not the fund strategy," he said. "It's important that the fund maintain the creativity that sets apart the hedge-fund industry from the basic long-only industry."
Stavetsky also is concerned that regulation could eliminate the reason for hedge funds to exist in the first place.
"We have to make sure we don't hurt the capital markets even more with regulation," he said. "What they're trying to do is remove all the risk out of [hedge-fund investing], but they still want all the risk returns. Investors have to take some responsibility, too."
Contact staff writer Wendy Tanaka at 215-854-2752 or firstname.lastname@example.org.
What Is a Hedge Fund?
Geared toward wealthy investors, hedge funds are unregistered pools of money invested in stocks, bonds, commodities and other securities. Managers of those funds can use speculative investing strategies, including:
Short-selling, which involves the sale of a security that is not owned by the seller.
Arbitrage, which involves buying and selling the same security that trades on two or more markets.
The minimum investment is typically $250,000, and an individual investor must have a salary of at least $200,000 and a net worth of at least $1 million.