Hedge Funds Escape Regulation: Should Investors Be Worried? (Knowledge@Wharton)

"According to the Treasury Department, the number of hedge funds, for example, has more
than doubled over the past five years, to more than 9,000, and their assets under management have quadrupled since 1999. Some experts believe that hedge funds account for a third to half of the trading in the U.S. stock markets."


So much money has poured into hedge funds that they have taken to betting on ever more exotic and illiquid investments, Marston notes. The effect can be seen in the shrinking risk premium, or extra return, demanded by people who invest in risky securities like junk bonds and emerging-market debt. "Right now I believe that in both the high-yield market and the emerging-debt market we have the most optimistic pricing I have ever seen in my career," he says. "They are assuming there are never going be any more devaluations, there are never going to be any more emerging-market crises....There is very little realization of the risk out there, in my view."

If something does go wrong -- such as an emerging-market country defaulting on its bonds -- hedge funds and other holders could rush to sell but not find enough buyers, causing a vicious downward cycle, Marston says, adding that there hasn't been a serious shock of this type since the Russian default crises of 1998 -- before the hedge-fund boom. "A lot of traders in the market haven't seen anything go wrong, and a lot of risk managers haven't tested their approaches. This is a little unsettling."