Hedge funds carry risks

Hedge funds are being blamed for just about every ill of the financial markets in 2007.

Aggressive, unregulated and secretive, these powerful investment pools employ any strategy they wish to try to make money for high-net-worth individuals unafraid of risk.

Their philosophy of going against the grain also has produced some side effects that are altering banking and personal investing:

• They've picked up risky business that would otherwise be imploding on bank balance sheets.

• Everyday investors, desiring a piece of the hedge-fund pie for less money, are moving assets into long/short mutual funds.

Congress, viewing collapse of the subprime lending market with alarm, is concerned about the involvement of hedge funds in the collateralized debt obligation market. Yet some experts consider that a positive hedge fund influence.

"The hedge funds and their rich clients are taking over significant risk that would otherwise fall on the banking system," said Stephen Brown, a finance professor at New York University's Stern School of Business. "They are clearly providing a conduit through which risk is being diverted from the public."

Nonetheless, hedge funds do themselves a "tremendous disservice" in the eyes of both regulators and investors by not being more forthcoming with financial information, and that means "the sins of the few will be visited on the many," Brown said.

Hedge funds are playing an increasing role in international banking.

"In the last 10 years, the dollar-yen trade has been an extraordinary investment for hedge funds and Japanese banks because they could borrow yen cheaply, invest in U.S. Treasuries with a 5 percent spread and leverage with little risk," said Charles Gradante, managing principal with the Hennessee Group LLC in New York, a consultant to hedge fund investors. "This definitely helped Japan refinance its banking problems."

For individual investors, the primary way hedge funds have made a difference is that investment firms have been encouraged to offer types of funds that travel apart from the herd. With high investment minimums aimed at millionaires only increasing at hedge funds, they're getting further and further out of reach for most investors.

As a result, the long/short mutual fund is capturing the lower end of the market for investors seeking diversification of their holdings.