Hedge funds have been much in the news this year as interest rate rises around the world have trimmed their performance, and even their ranks.
These short-term problems have caused some investors to question the usefulness and safety of hedge funds as investment vehicles.
But the long-term successes of investors like George Soros and others more than offset the disappointments of this year in the minds of other investors.
These results have attracted the attention of pension funds, foundations and endowments. All three institutions need higher-return investment vehicles to offset the low returns expected from mainstream stock and bond portfolios in the rest of the 1990s. Are hedge funds suitable for such tax-exempt investors?
There is no reason a hedge fund selected with due diligence and careful consideration of the risk tolerance of the specific institution could not be a suitable investment for a defined benefit pension fund, an endowment or a foundation.
Hedge funds often take higher risks than ordinary money managers, but the successful ones also often generate higher risk-adjusted returns. Almost certainly, hedge fund investments would be used for only a small part of any institution's total portfolio, much as venture capital - also a higher risk, higher expected return investment - is used.
Pension funds, endowments and foundations have access to professional investment staffs and high-quality expert advice from consultants and academics. So for them, hedge funds may indeed be acceptable investment vehicles.
But there is one sector of the pension system where hedge funds may not be appropriate - defined contribution plans. As reported elsewhere in this issue, the Securities and Exchange Commission is to reconsider a proposed ruling that hedge funds would have to register under the Investment Companies Act of 1940 if they were to operate in the defined contribution market. This would expose hedge funds to a level of disclosure they could not accept.
It is mind-boggling that hedge fund managers are even interested in the defined contribution market. The level of disclosure required by the SEC would be nothing compared with the disclosure and participant education that would be needed before a hedge fund would be a suitable option in a 401(k) or other defined contribution plan.
Sponsors of such plans have their hands full educating employees in the basics of stock and bond investing, risk and return, and asset allocation. Their efforts in these areas after several years have barely begun to have an impact on the level of investment knowledge of defined contribution participants.
How then, could employees be expected to understand the intricacies of hedge fund investing, the risk-and-return tradeoffs, the uses and dangers of leverage?
Hedge fund managers would be well advised to resist the temptation that billions of dollars of defined contribution plan assets appear to offer. They may persuade a few sponsors to offer hedge funds as a defined contribution option, but the short-term gain may not be worth the long-term costs.
Imagine the outcry in Congress, imagine the demand for greater regulation, imagine the employee lawsuits against sponsors, if a disaster dragged down defined contribution plans. Hedge funds for defined benefit plans? Possibly. For defined contribution plans? No way.