Leadership Spotlight

Continued from previous page

It’s unclear whether regulators will push this agenda, especially since funds, egged on by investors, are already largely disclosing more and following better-defined processes than they used to.

And regulators are likely most interested in potential systemic risks. The New York Federal Reserve, for instance, engineered a bailout of the Long-Term Capital Management (LTCM) fund in 1998 because its losses threatened banks and other lenders, an event regulators are keen to avoid looking ahead.

Herring says that, on the one hand, hedge funds can have the flexibility and often the courage to take the other side of markets when traditional investors are selling. “That’s a very good thing” for the health of the system, he says. The danger is another LTCM—in the form of trouble at a big fund or a group of funds all with similar market bets.

This could have happened last summer when credit briefly all but dried up—something that could have triggered major problems for hedge funds, because many of them rely heavily on borrowed money. But as it turned out, the bigger losses appear to have been taken by banks and Wall Street brokers.

For now, that tends to vindicate the U.S. regulators’ strategy to date, which is to scrutinize regulated banks and brokers that lend to hedge funds, indirectly controlling the funds’ borrowing and risk-taking capacity.

Nonetheless, “If we have another blow-up that has the systemic implications of LTCM, I think there’s going to be tougher talk about regulation,” Herring says.

An Alluring Career Option

For those within it, the hedge fund industry can be a pot of gold. In 2006, three top fund managers each took home more than $1 billion, according to Alpha magazine. The top 25 earners garnered more than $14 billion among them.

Indeed, for those who enjoy money and investing, working for a fund is an alluring option. Finerman, for instance, always knew she wanted a career in investing; thus, Wharton was the only school she applied to. “For someone with laser-like focus on being in capital markets there was no other alternative.”

Finerman is one of just a few women heading hedge funds. “It’s really only a handful,” she says, adding that she believes the balance will change over time. “It’s a very male-dominated world, but I’m comfortable in it. I can be a little different, and that can sometimes work to my benefit.”

For some, the thrill of making money for investors and themselves and the belief that they fuel the capitalist engines of growth and prosperity are satisfying enough. Steinhardt says he persuaded himself he was doing something of economic importance. Now, with the benefit of hindsight, he isn’t so sure. “I would grudgingly think hedge funds are not in any way ennobled in their effort to get rich.”

Even so, there’s no denying that his hedge fund days have made him wealthy enough to devote plenty of money and much of his time to philanthropy from his office overlooking New York’s Central Park.

Of course, there’s a danger that the recent accumulations of wealth in hedge funds and private equity provoke a backlash—something Gaine of the MFA says he has so far seen mostly in the form of calls for higher taxation on alternative investment managers, whose compensation, particularly in the case of private equity, is often taxed at the capital gain rate rather than the higher income tax rate.

But even if higher taxes come to pass, they aren’t likely to dent the attractiveness of the industry much, whether for budding hedge fund managers or for investors, experts say.

A Bumpy Road Ahead

Back in 2004, Asness pointed out that in considering then novel-seeming hedge funds, investors should consider that at one time, they might have asked: “Why mutual funds now? Why money market funds now? Why index funds now?”

“Why hedge funds now?” is a question that isn’t asked much any more, but the industry is still maturing and shifting. Investor expectations may need to adjust, as may fund managers’ hopes of collecting generous fees without having to divulge much about their methods, industry observers say.

“The road will not be short, and certainly not free of bumps,” Asness says. He added that “bump” was a euphemism for “some people losing a lot of money at some point.” But investors shouldn’t be surprised by the occasional hedge fund blow-up, provided they were told about the kind of risks being taken.

Herring has another view of the future, with some big funds diversifying into other financial services as Citadel, for example, is doing. “We may see some of them reinventing themselves as other kinds of institutions,” he says. Does that mean even high-flying Goldman Sachs bankers need watch their backs? Herring puts it this way: “It’s not just commercial banks that may need to worry about disintermediation.”