When the investment fund called Long-Term Capital Management almost collapsed last August, the event sent tremors throughout the financial world. Many feared that Long-Term Capital’s problems would spread to other institutions as the prices of financial assets generally fell. Suddenly attention was concentrated on the arcane and mostly unregulated investments known as hedge funds; they apparently have much more influence over global financial markets, and indeed the economic lives of most people, than was generally realized.
A hedge fund is a limited partnership which, unlike a traditional mutual fund, has no restrictions on the types of investments it can buy and sell other than those its managers impose on themselves. It can also borrow several times its capital to make these investments. Long-Term Capital Management was one of the nation’s largest hedge funds. Headed by John Meriwether, formerly of Salomon Brothers, and with two Nobel Prize winners in economics among its partners, it was also one of the most respected. After it lost most of its $4.8 billion in capital last summer—at the time when worldwide markets were falling in reaction to financial turmoil in East Asia and Russia—the Federal Reserve decided that it had to mobilize private resources to save the firm. More than a dozen banks and other institutions were asked to invest in it and take over its operations, and they put up some $3.6 billion to do so.
Because Long-Term Capital had borrowed extensively, its actual investments may have amounted to as much as several hundred billion dollars, if not more. With the value of financial assets in general falling, the turmoil could have spread well beyond the investors directly involved with Long-Term Capital to many other domestic and international institutions. In fact, major commercial and investment-banking firms in Europe and the United States reported losses of hundreds of millions of dollars that were related to hedge fund activity. Several major hedge funds, including two of the largest, Julian Robertson’s Tiger Fund and George Soros’s Quantum Fund, also reported substantial losses of billions of dollars.
There are probably about fifty hedge funds today with capital of more than $100 million and some three hundred with $50 million or more. There may well be several thousand funds in all, many and perhaps most with capital of no more than $1 or $2 million. Precise data are not available because hedge funds are generally unregulated. According to federal law, if the funds have fewer than five hundred investors, each with a minimum net worth of $5 million, the disclosure and other regulatory requirements the Securities and Exchange Commission (SEC) imposes on mutual funds do not apply. For any individual, the minimum investment in one of these funds is $500,000. The government has concluded that investors with sufficiently high net worth are sophisticated enough or rich enough to afford expert advice, making basic protective measures unnecessary.
Many American firms also run off-shore funds, also unregulated, which are generally closed to …