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All eyes on hedge funds
Scandal at Bayou, weakening returns, and now new SEC chief put wealthy investment pools on the spot.
September 22, 2005: 2:13 PM EDT
By Amanda Cantrell, CNN/Money staff writer
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NEW YORK (CNN/Money) - Hedge funds have gotten a truckload of publicity in recent years, given their rapid growth, recent popularity with more conservative investors like pension funds, and some high-profile blowups.

These investment pools, which cater to wealthy individuals and employ a wide variety of investment styles, have always generated big headlines, given the big bucks successful managers make.

They also get a ton of attention when one of them blows up after a trade or series of trades goes bad, or if they're too highly leveraged, meaning they've borrowed money to make investments.

This year has kept reporters particularly busy.

This summer, two bond-rating agencies cut General Motors' corporate bonds to junk status, leading some hedge funds and Wall Street trading desks to take big hits on complex trades involving the automaker's stocks and bonds. The bonds plunged in value, leaving bondholders and other investors with big losses, at least on paper.

Around the same time Kirk Kerkorian said he was buying GM stock, which drove the shares sharply higher. A handful of hedge funds were said to have taken a double hit by being on the wrong side of both trades, holding the bonds and selling the stock short.

Meanwhile, several funds have come under the scrutiny of federal regulators this year for allegedly defrauding investors. Two principals of KL Financial, a $200 million, West Palm Beach, Fla., hedge fund, fled the country after the SEC sued them in March for lying about their funds' returns and issuing bogus reports to investors.

More recently, Daniel Marino, the chief financial officer of Bayou Management LLC, admitted to years of cooking the books in a suicide note, though he never killed himself, according to media reports.

Marino and Bayou's founder, Samuel Israel III, are now being investigated for falsifying returns to cover up trading losses, and state officials in Arizona seized $100 million in funds believed to belong to Bayou's investors, according to court documents. Federal prosecutors filed a suit alleging that Bayou's managers raised $300 million from between 1998 and 2005 by lying to investors about the fund's returns and other issues.

Can the aftereffects of a hedge fund blow up trickle down to ordinary Americans who don't play in these markets?

That question hasn't truly been put to the test, but there was a close call in 1998 when a Connecticut hedge fund, Long Term Capital Management, nearly blew up until a consortium of Wall Street firms, encouraged by the New York Fed, bailed it out for $3.5 billion.

Some hedge fund experts noted that the markets absorbed the impact of the GM debt downgrade fairly quickly, even though losses were said to amount to hundreds of millions for some funds and Wall Street investment houses trading for their own accounts.

But others, including Andrew Lo, director of the MIT Laboratory for Financial Engineering and a manager at the hedge fund Alpha Simplex Group, have cautioned that if there is ever a so-called systemic shock -- a major event in financial markets that ripples around the world -- we could be in for serious trouble.

Such a shock could spark a rush for the exits as investors all try to sell at once.

"That kind of a massive coordinated sale of these assets would cause a further decline in prices, much like a cascade effect," he said.

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