Hedge funds in a spin

The market's sharp-shooters have had free rein in making billions. But now the regulators could put them on a leash

Man Group, the world's largest quoted hedge fund, unveils annual results this week that are expected to be its best ever. Like the entire hedge fund industry, it has been on an amazing run. In 2000 Man had $4.7bn (£2.5bn) under management; today it has more than $43bn.

But this stellar growth won't be grabbing all the attention at the results. Sharing centre stage will be a potential lawsuit in the US, where its American arm stands accused of abetting an alleged $140m fraud by a Philadelphia hedge fund.

It is not alone among hedge funds in feeling the heat. Calls for greater transparency in the industry, and tighter control, are growing louder. That trend has been exacerbated by the market turmoil in recent weeks - something that may have been influenced by these funds.

After years of operating in anonymity, unfettered by regulation and fabulously remunerated, hedge fund managers face a tide of new rules - and they don't like it. They claim that the light regulatory regime in the UK is crucial to the industry's success, and any change to this could be damaging. "Managers are worried. They have an incredibly profitable franchise and regulation poses the biggest threat," says an industry source. "The [regulators] have life or death power over them."

A Commons Treasury Select Committee led by John McFall is set to publish a report early next month that will discuss, among other things, whether an overarching European regulatory scheme for the sector should be put in place. The US watchdog, the Securities and Exchange Commission, has already passed a law requiring US funds to register as investment advisers, which means they have to disclose some of their holdings. And the City regulator, the Financial Services Authority, set up a special unit last year to investigate the industry.

Why all the attention? Together, hedge fund managers are sitting on a cash pile that has tripled in just six years to over $1.5 trillion usually held in offshore vehicles, mostly in the Cayman Islands. Before even lifting a finger to invest their clients' money, the managers - an intelligent, aggressive, highly secretive bunch of just a few thousand people stationed mainly in New York and London - bring in annual fees of more than $30bn, after which they can look forward to a standard 20 per cent commission on profits. According to Institutional Investor magazine, the leading executives at the top 26 hedge funds earnt an average of $363m last year.

How do they make such big money? By placing big, and often risky, bets on the rise and fall of everything from normal company stocks, to distressed debt to commodities and currencies. You name it, they buy and sell it. Unlike mutual funds, they pledge absolute returns, regard- less of the fluctuations of the equity market, by employing an array of complex trading techniques such as short-selling.

Critics deride them as short-term investors prone to market abuses that will do whatever it takes to make a quick profit. Others see them as shareholder guardians who are are becoming more bold in challenging boards on strategy or forcing change at the companies in which they invest.

"They are the one last vestige of unfettered capitalism holding managers to account," says Bert Denton, the president of the broker-dealer Providence Capital. He admits that some, however, may engage in activities that sail close to the wind. "Some are good guys and some are bad hombres who, given hedge fund records, are dealing on tomorrow's news today, and I hope they get caught."

While the money has flooded into some funds, the overall performance has begun to wane. During the three-year period ending December 2005, the FTSE 100 gained roughly 40 per cent, while the Greenwich Van Global Hedge Fund Index rose 35 per cent. "Most people thought this was the goose that laid the golden egg and that the low-volatility, high-return path would continue in perpetuity," says Justin Dew, a senior hedge fund strategist at credit-ratings agency Standard & Poor's. "Frankly, that's not possible." And as returns dip, the rewards, especially for managers who invest in other hedge funds through so-called funds of hedge funds, are likely to fall.

Meanwhile, there is the spectre of regulation - the last thing the industry wants or, it claims, needs. Gordon McAra, of the Alternative Investment Management Association, a trade body, says that given the exacting demands of the sophisticated investors who entrust their money to hedge funds, no more rules are necessary. The internal controls of individual funds, he says, "are already to a very high standard".

For the Government, regulation is a difficult line to walk. It is "concerned about the risks [hedge funds] pose but also about keeping London a benign place for the industry, " says Angela Hayes, a partner at law firm Lawrence Graham.

The noises coming out of the FSA, though, have spooked London managers, who control a fifth of the world's funds. Industry sources point to a recent meeting between representatives of London's leading hedge funds and the FSA's special hedge fund unit where Thomas Huertas, a member of the unit and the head of the regulator's wholesale firms division is said to have threatened to "shut down" any fund found guilty of market abuse.

Managers at the meeting, who until that point had enjoyed the open dialogue being fostered by Andrew Shrimpton, the leader of the special unit, were said to have been "gobsmacked" at the remark. "Regulators are playing catch-up with the market, getting to understand what [hedge funds] do and how they work," says a source. "They don't understand fully the creature they are trying to regulate."

Phillip Jabre of GLG, one of London's biggest hedge fund firms, is fighting a fine of £750,000 levied by the FSA earlier this year for alleged market abuses. In his appeal, he is arguing that because the trades in question were made on the Tokyo Stock Exchange, the FSA cannot penalise him. The case is being followed closely, as it is seen as an acid test of the FSA's ability to regulate managers who may be based in London but operate often diffuse operations in other markets.

The FSA hedge fund unit is understood to have actions "in the pipeline" against other funds, but is waiting to act until the verdict on Mr Jabre is delivered.

Meanwhile, investors continue to pile in. Man Group raised $2.3bn earlier this year in its largest global hedge fund offering, and the Close AllBlue Fund floated a £145m fund of funds last week - the largest of its kind in the UK to date.

If that trend continues, the regulatory screws may well be tightened - which is fine by those players for whom image is important. "The more discussion there is about hedge funds, the better," says Close AllBlue's managing director, Mark Gordon. "It will help remove the pariah view people have of them."

The long and the short of it

Hedge funds began life as investment vehicles designed to reduce risk and preserve capital in all market conditions. The term is an umbrella description for funds that are typically private, run by professionals with a stake in the fund, and requiring a significant initial sum - often more than $1m (£534,000) - from investors.

Regulation has historically been light as the rich were considered able to look after themselves. However, managers have become more aggressive, often using elaborate investment strategies to boost returns, with the ability to "short-sell" being perhaps their most distinctive feature.

Short-selling means managers borrow shares held by other investors for a fee, and then sell them. The idea is that they will then buy them back later at a lower price - so pocketing the difference and making a profit in a falling market.

Although the funds have been going since 1949, it was not until the 1990s and, in particular, two high profile events, that they caught the public imagination.

George Soros became known as the man who broke the Bank of England following the events of 1992, when his Quantum Fund bet against the pound, making profits of £1bn and contributing to sterling's ejection from the European Exchange Rate Mechanism.

And the once seemingly bullet-proof Long Term Capital Management (LTCM) was brought to its knees in 1998 when it was unable to cope with the market turmoil exacerbated by the Russian financial crisis. The highly leveraged American hedge fund was left with a $4.6bn loss.

Jill Ferguson