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Week of 4.13.07

Interview: Journalist Duff McDonald

NOW interviewed journalist Duff McDonald about his April 16, 2007 New York Magazine cover story on the power and people behind hedge funds. Here he provides more details and insight about his report.

NOW: Can you explain what a hedge fund is?

DUFF MCDONALD DUFF MCDONALD (DM): Hedge funds are investment vehicles. Like mutual funds, they pool together investors' money and invest it in search of profits. They're different from mutual funds in a few ways, however. First, they do much more than merely buy or sell stocks and bonds. They can use short selling (a way to bet that the price of a security will drop instead of rise) and "derivative" securities such as options and futures, and they also utilize leverage (borrowed money) to amplify returns. Second, they charge much more than mutual funds in terms of fees. And third, the minimum investment tends to be a lot higher than the typical mutual-fund minimum of $2,500 or so.

NOW: Why should ordinary people care about hedge funds, if at all?

DM: Hedge funds as a whole now account for some $2 trillion in invested assets. And they're some of the most frequent traders in the markets. It's useful to have an understanding of their growing influence, if only to have a fully informed view of the factors that influence the markets. At the same time, institutional investors such as pension funds are increasingly allocating money to hedge funds. So, many of us are already investing in hedge funds, whether we know it or not.

NOW: What's the most common misperception about hedge funds?

DM: That they are, by definition, risky. As explained above, a hedge fund is merely an investment vehicle and nothing more. Some can be extremely risky. But others might have less risk than anything in your own portfolio. It all depends on what they invest in.

NOW: How much pension money is now moving into hedge funds, and is it a risk?

DM: Pension funds are allocating anywhere from 5 to 25 percent of their assets into "alternative investments"-which includes hedge funds, real estate, private equity, and other nontraditional-asset classes. Is it a risk? Sure, in the sense that all money invested in the markets is at risk. Has the growth of hedge funds added any additional risk to the markets? It's possible, particularly owing to their growing appetite for leverage, which, by amplifying returns on the way up, can also do so on the way down. On the other hand, hedge funds can be the buyers of last resort in the event of some corporate meltdown or when a hedge fund like Amaranth implodes-so in that sense, they can remove risk from the markets, as opposed to adding to it.

NOW: Do exotic trading strategies associated with hedge funds increase the volatility of the stock markets?

New York magazine cover - Behind the Hedge DM: It's hard to say. Hedge funds do engage in greater-than-average trading activity. But it's unlikely that they're the proximate cause of something like the rapid rise in oil over the past several years. The specific causes of that -- tension in the Middle East, growing demand from China and India, weather-related demand shifts -- are not the doing of hedge funds but the result of all sorts of geopolitical, economic, and other factors. Of course, hedge funds have no problem trying to capitalize on that volatility.

NOW: Can you describe the dinner Senator Schumer orchestrated in late January for the top hedge-fund managers and why this meeting was significant?

DM: Having not actually been at the dinner, it's hard to relate much more than the brief recollection of one of the attendees. Schumer's message was essentially that the hedge-fund community should think long and hard about being a little more forthcoming with the government, with the implicit threat that if they didn't voluntarily become so, Schumer had means at his disposal to make it happen anyway. There's more than one camp in the hedge-fund universe, one of which has a libertarian bent, and those folks were rubbed the wrong way by Schumer's message. Others saw it as an inevitable discussion that they knew would come some day. The most interesting fact about the dinner, though, was just how much financial power was convened around a single table. Those attending controlled hundreds of billions of dollars.

NOW: Are hedge-fund managers poised to make a big impact on the 2008 presidential campaign?

DM: They will likely make a bigger impact than members of the hedge-fund community have ever made before, as more and more of them become politically involved. Will they have an outsize impact relative to all other fund-raising activities? That's unlikely. While there's a small group of people getting very rich, corporate America and Wall Street contribute far more on an absolute basis than do hedge-fund managers as a group.

NOW: How much have Senator Hillary Clinton and other political candidates come to rely on hedge-fund managers and the financial services industry for fundraising

DM: Again, while there are some hedge-funders -- or hedge-fund spouses -- very active in political fund-raising (Richard Perry's wife, Lisa, can surely be counted as a friend of Hillary), it's important to remember that this is relatively new wealth for many of them, and they're only getting started at feeling their way around the nexus of money and political influence.

NOW: Is government regulation of hedge funds on the way? Is that a good thing?

DM: At the moment, it doesn't look like there are any additional regulations coming down the pike. Treasury Secretary Henry Paulson and his team are keeping an eye on hedge funds, but their current position seems to be that with traditional Wall Street banks falling under quite strict regulation, there's not a need to specifically target hedge funds. Hedge funds, after all, are customers of those same banks, and the sense is that the banks are pretty focused on their own exposure to hedge funds already. That said, another big meltdown akin to Long-Term Capital
Management or Amaranth and the regulators will be champing at the bit to introduce new oversight.

NOW: What is "the great unwind," and how dire could its consequences be?

DM: The great unwind is a scenario suggested by analysts at European investment bank Dresdner Kleinwort in which a series of credit defaults ripples through the markets, causing the bottom to fall out of stock and bond prices. In the direst scenario, you have a stock-market crash. But there's also the possibility that such a shakeout is just that -- a way that some of the weaker players are filtered out of the market. And of course you have everything in between.