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Financial Experts Debate Pros and Cons of Hedge Funds

Some of the financial world's largest investment funds are getting bigger, more numerous and more likely to hurt the economy if they collapse. Hedge funds, which are investment vehicles made up of lightly-regulated pools of money, grew by nearly one-third over the past year. Critics say these funds are so big that they can unfairly manipulate markets and want government to regulate them more closely. Supporters say hedge funds improve markets and warn that more regulation could hurt investors and slow innovation. VOA's Jim Randle reports.

There are at least 8,000 hedge funds and they control a gigantic $1.4 trillion dollars of investments.

That makes the fast-growing hedge fund industry slightly larger than the economy of Canada, and somewhat smaller than the gross domestic product of Brazil. Some hedge funds make huge profits, but others go broke and cause serious problems.

University of Maryland Law professor and former financial regulator Michael Greenberger says regulators, members of Congress and others have been taking a close look at hedge funds

"There is beginning to be a concern about the impact of hedge funds on the economy and a movement toward doing something about that," Greenberger says.

A hedge fund is a pool of investment money collected from individual investors or institutions by a fund manager and invested on their behalf. The aim is to make money by finding stocks, companies or other things that are undervalued and buying them. Or fund managers may find other assets that are overpriced and make an investment bet that the price will go down.

Only a limited number of large, wealthy and presumably sophisticated investors are permitted to join hedge funds. So these investment vehicles face less regulation and have to disclose less information than other investments, such as mutual funds.

And hedge funds are allowed to use much more aggressive – and risky – strategies than mutual funds. For example, hedge funds can borrow stock or money to increase their investments. That makes greater profits possible, but also exposes the fund to greater losses.

If the investments go bad, then the fund might not be able to repay the loan, which could put the lender out of business.

Professor Greenberger warns that if a number of large hedge funds collapse at once, both the investors as well as the institutions that loaned money to the fund are hurt – and this could create a ripple effect throughout the financial system. He says this nearly happened in the late 1990's.

"The granddaddy of calamities of hedge funds was the 1998 near-collapse of Long Term Capital Management,” he says. “It was at the time, the world's largest hedge fund. The conventional wisdom of that time was that if it failed in the long term, it would have caused terrific systemic collapse in the American economy. It was not too far-fetched for people at that time to be talking about depression, economic depression."

Investment adviser Bill Mann of The Motley Fool company says the funds can sometimes use their huge pool of investment money to unfairly manipulate the market price of commodities, stocks, or other investments.

For instance, things like crude oil, Asian currencies, or some stocks.

"They absolutely could manipulate the market and I think it is important to note that in all likelihood, they do manipulate the market," he says.

Mann says an unscrupulous hedge fund manager could drive down the stock price of a company he wants to buy by spreading false reports that the company has problems. Or a fund could sell large quantities of a particular stock, flooding the market and driving down the price, and then quickly buying up every available share at a lower price.

Some legislators and experts say governments should regulate hedge funds more closely and require them to disclose more about their actions to discourage improper behavior.

But some hedge fund managers say there are plenty of laws that already ban activities such as fraud and insider trading. George Mason University researcher Houman Shadab says it would be unwise to force hedge funds to disclose secret trading strategies.

"It would be like forcing a cook or chef to reveal his secret recipes, the things that give him a competitive advantage over other hedge fund managers," he says.

Shadab says hedge funds make markets more liquid by increasing the number of investors bidding on stocks and other assets.

Top U.S. Bush administration economic officials recently examined the issues surrounding hedge funds and decided against major changes in regulations that govern them. European officials are said to still be considering stronger regulations for hedge funds.