By Julie Creswell

(FORTUNE Magazine) – IF THERE WAS ANY DOUBT THAT THE new power titans in the world of finance are hedge funds, the offer by Highfields Capital Management to acquire electronic retailer Circuit City for $3.25 billion in February surely cemented the fact that they are the force to be reckoned with.

Corporate CEOs have long groused that hedge funds were having undue influence over the volatility of their stocks or that their short-selling activities were undermining long-term investors. Those were the easy days. An increasing number of hedge funds are taking activist stances in the stocks they own--demanding changes in strategy and management compensation, putting up their own slates of directors, and even bidding for the companies themselves.

For years hedge funds shunned public battles, fearing they might spark unwanted attention from regulators, but now the SEC is forcing the funds to register anyway. Furthermore, with the hedge fund world becoming more crowded, funds are doing whatever they can to find an edge. "Hedge funds are not making the 20% returns in the market the way they did in the 1990s," notes Charles Gradante, a managing principal at Hennessee Group, which advises institutions and individuals on hedge fund investments. "Now they're looking for companies they believe are undervalued and where they can press the boards to take action quickly."

For many of these "activist" hedge funds, the goal is to publicly challenge management, forcing them to make a move--preferably one that jolts the stock. In December, Scott Sipprelle of Copper Arch Capital sent a scalding letter to the board of brokerage firm Morgan Stanley urging them to dump a number of underperforming businesses. A former Morgan Stanley executive who owns a small stake in the company, Sipprelle followed up that salvo two months later with another letter challenging the way the board calculated CEO Philip Purcell's $22 million pay package. "If you have a bunch of small shareholders, not one person owns enough to have much of a say in change," says Tom Hudson, a portfolio manager at Pirate Capital. "But as hedge funds get larger, you're going to see them become more active and do things with larger-sized companies." Pirate recently announced plans to launch a proxy battle to replace the entire board of Cornell Cos., which provides privatized correctional services.

And while many observers assume Highfields' bid is really a maneuver to flush out other potential buyers, that may not necessarily be true. Highfields could be taking its cue from the playbook of hedge fund manager Edward Lampert. After buying a giant stake in Kmart, Lampert then orchestrated its $11 billion merger with Sears. Lampert will be the chairman when the deal closes, likely in March.

One thing is certain: Managements can't ignore these activist investors. When Barington Capital Group's demands last year were met with a deaf ear from executives at shoe manufacturer Steven Madden, it threatened to launch a proxy battle to replace the CEO. The company caved in, adding an independent director with retailing background to its board for starters. "We initially met with some resistance," admits Barington's Jim Mitarotonda. "But we got them to take all of the steps we felt were necessary." Like Steven Madden had a choice. -- Julie Creswell