With U.S. midterm elections approaching fast, in a year where experts predict shakeups in the House and Senate, politicians across the nation are working on polishing their rhetoric and preparing the platforms that reflect the issues that concern voters most: healthcare, homeland security and...hedge fund regulation?

If anyone needs an image consultant this campaign season, it might be hedge funds. The $1.2 trillion industry-triple the size it was a decade ago-successfully resisted regulators when the U.S. Appeals Court called the Securities and Exchange Commission's registration rule "arbitrary" and deemed it invalid. But instead of enjoying a jolt of renewed public faith, hedge funds are facing claims about the dangers of "retailization," particularly in light of recent interest from pension funds, and an onslaught of suggestions about how to tighten control.

"Hedge funds are the Wild West of our financial markets," said Sen. Orrin Hatch (R.-Utah).

"Hedge funds are a regulatory black hole that lack even minimal disclosure and accountability required of mutual funds and other financial institutions," said Connecticut Attorney General Richard Blumenthal. Perhaps in response, historically apolitical hedge funds have nearly tripled their campaign contributions this midterm cycle, kicking in $3.1 million toward politicians' pots, mainly Republicans, compared to $1.1 million two years ago.

Last week, even the mainstream media was flooded with headlines about whether hedge funds are losing money and whether more, strapped for cash, will go public. Most notable were the headlines highlighting the steep losses at Amaranth Advisors in Greenwich, Conn., which made a bad bet on natural gas futures and lost $5 billion in a week, chopping its $9 billion value in half.

The same day news about Amaranth broke, U.S. Rep. Michael N. Castle (R-Del.) introduced a bill calling for the White House Working Group on Financial Markets to study the risks hedge funds present, the impact of their growth, whether investors are adequately protected and whether leverage is appropriately constrained, and to recommend laws, disclosures or oversight programs.

"Transparency in our financial system is important for market discipline and investor confidence," said Castle, who is chairman of the House Committee on Financial Services.

Hedge funds have, in part, attracted the attention of leaders and laymen because of their recent exponential growth. In the past decade, the industry has swelled, from $324 billion under management in 1990 to more than $1.2 trillion today. Once considered a parlor game for the uber-sophisticated and ultra wealthy, more and more institutional investors, including pension funds, have joined in.

But unlike other industries that see sudden growth and are celebrated as signs of a robust economy and the triumph of entrepreneurs, hedge funds' tendencies toward secretive strategies and limited disclosures are increasingly being painted by politicians as a clear and present danger.

"It's just pandering to the public," said Philip Goldstein, a partner at Bulldog Investments in Pleasantville, N.Y., who single-handedly took on the SEC in the case that ultimately got the registration rule overturned.

While it's true that hedge funds are not as transparent as the investment vehicle of the masses, the mutual fund, it's equally true that because of the asset hurdles hedge funds force investors to pass before qualifying, as Goldstein noted, "Your average hedge fund investor is not Joe-six-pack."

Those within the industry say pre-qualified investors are savvy enough to understand that danger and wealthy enough to tolerate some loss. "Who really cares if a super-rich guy lost their money because managers traded in natural gas?" said Paul J. Irvine, a professor at the Terry College of Business at the University of Georgia.

But the politicians don't see such a clear differentiation, and as much as investors stand to lose from a poor hedge fund investment decision, there's perhaps even more political capital to gain for politicians who successfully portray hedge funds as murky, secretive players-and vow to vet them in an effort to protect voters.

"The whole idea of riding herd on Wall Street has always been an area that people pay attention to," said Maurice Carroll, director of the Quinnipiac Polling Institute at Quinnipiac University in Hamden, Conn.

But unlike Enron or WorldCom, or even the implosion of hedge fund Long Term Capital Management in 1998, in the case of Amaranth, no rules were bent, investors fleeced or laws broken. Just a young, possibly overconfident, trader made some really bad investment decisions.

"What's the connection between regulation and poor judgment?" Goldstein asked.

What's more, in the case of Amaranth, it appears the markets worked exactly as designed, said William Natbony, a senior financial services partner with Katten Muchin Rosenman in New York. While Amaranth lost big by betting long on gas futures, someone else must have bet short on gas, and probably made a bundle.

The question is whether legislators should be spending time penning laws to regulate this specialized industry, and whether taxpayers should spend the money enforcing them.

"Hedge funds, by nature, are very entrepreneurial, taking advantage of certain opportunities in current regulatory code for portfolio construction," said Ryan Tagal, a hedge fund analyst with Chicago-based fund tracker Morningstar. "Most of them consider themselves very cutting edge, which makes it harder to put a regulatory schema on them," he said.

And while election day is only six weeks away, it's going to take a long time to collect and adequately analyze the data to determine whether the growth among hedge funds has increased volatility in the markets, Irvine said. "If they are, we have to decide whether it's costly and if so, to whom?"

In the case of Amaranth, it was costly to members in at least one public pension plan. The San Diego County Employees Retirement Fund has projected a $175 million hit.

And that's unusual. Most pensions that pepper their portfolios with hedge fund holdings only do so in small doses, said Ferenc Sanderson, a research analyst at Lipper Hedgeworld.

The real risk is allowing political grandstanding to lead to poorly thought-through legislation or over-regulation, causing hedge funds to move to a more amenable jurisdiction, Sanderson said. That could really affect investors, he added.

"Hedge fund catastrophes make for great headlines and politics, but generally do not make for great law," Natbony said. "We shouldn't politicize what is, overall, the cornerstone of our society, which is a smooth running financial system."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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