Hedge funds are the latest
scapegoat for woes, but
their power is limited

NEW YORK » It's become very popular to blame once high-flying hedge funds for an array of Wall Street's ills, from rising oil prices to the market's April slump. And why not? They're unregulated, have grown enormously in dollar terms and yet, on the whole, they're failing to produce solid returns so far this year.

A hedge fund is a kind of mutual fund that requires a large initial investment, and has been traditionally aimed at the wealthy. Hedge funds don't invest in a stock or bond and hold it the way most funds do -- instead they buy and sell quickly, and can make money by betting that a given stock will go down as often as they bet it will rise. Their rapid trades on even the slightest movement in a stock hearken back the day traders of the 1990s, but with hundreds of millions of dollars at a time.

And like those day traders in the dot-com era, hedge funds have become Wall Street's favorite bogeyman when markets fail to perform.

For example, when oil prices topped $57 per barrel last month and were fluctuating by more than $1 a barrel on any given day, hedge funds were blamed for betting so much money on a rising price for oil that it became a self-fulfilling prophecy.

Or in the confusing merger battle between Verizon Communications Inc. and Qwest Communications International Inc. over MCI Inc., hedge funds were blamed for keeping prices volatile as they tried to make money on the spreads between the bidders' and MCI's stock prices -- and arguably ended up overvaluing MCI and undervaluing the bidders.

Yet despite the fact that the global hedge fund industry now has more than $1 trillion under management, up from $480 billion in 1999, it's difficult to make a case that hedge funds can be blamed for 2005's sluggish market. Indeed, most measures of market volatility remain very low. And although that $1 trillion represents money that can be brought to bear very quickly in the market, it's just one-seventh of the money under management in the nation's mutual funds. Moreover, only a fraction of hedge fund money gets put to use in any given trading day.

At worst, hedge funds tend to accentuate or blunt a trend already in place. However, the industry's problems are having more subtle effects on the markets that have already had an impact on the everyday investor.

The problem is that while the number of investing strategies are relatively finite -- and the amount of stocks, bonds and commodities available to execute those strategies are likewise numbered -- the amount of money flooding into hedge funds has seen stunning growth, prompted by strong post-dot-com returns when the market was slumping.

Many hedge fund strategies rely on counter-intuitive thinking -- do something that other people aren't. But when everybody's thinking the same thing, the strategy is no longer counter to the prevailing trend -- it IS the trend. And that makes it harder to make money.

"There are a limited number of individual events where any given strategy can be implemented," said Chris Johnson, manager of quantitative analysis at Schaeffer's Investment Research in Cincinnati. "The number of players has gone up, but the number of positions on the field hasn't."

For example, a given company's stock would likely rise after a strong earnings report. But if enough hedge funds had bet lower, then the stock wouldn't rise as much as it would have otherwise, or may even fall. That can be frustrating for traditional retail investors hoping to see a stock rise in value commensurate with its performance,

"Eventually, the stock will get in line with its overall value, but on a day to day basis, investors will just have to get used to this feeling of getting whipped around and taken for a ride," Johnson said.

And sometimes the hedge funds' strategies don't work. Earlier this months, a number of hedge funds lost money on General Motors Corp. They had bet that the stock would continue to fall, while the company's bonds would hold steady. But when billionaire investor Kirk Kerkorian bought up GM stock, the stock price rose. The next day, the company's bonds were downgraded to "junk" status, and bond prices fell.