Many of the new hedge fund entrepreneurs are embracing a strategy of pinpointing temporary market inefficiencies, the exploitation of which is expected to yield above-average rates of return.  For the time being, most of the low-hanging fruit of readily available profits has already been picked by the managers of the massive influx of hedge fund capital, leaving as a byproduct much-more-efficient markets and normal returns.

However, I continue to believe, as I did in the aftermath of the LTCM episode, that ensuring sound credit-risk management by the regulated banks and securities firms that are hedge funds' counterparties is the most promising approach to addressing concerns that excessive hedge fund leverage could threaten the financial system.  Some may believe that government regulation of hedge fund leverage would be more effective.  But it would be very difficult to design a set of capital requirements for hedge funds that is appropriately sensitive to the diversity and flexibility of investment strategies that different funds employ and to the lack of diversification in the portfolios of individual funds.  More important, government regulation of hedge funds could undermine the effectiveness of market discipline if counterparties incorrectly assume that government regulation is so effective that it obviates private prudence.

Although hedge funds help improve the efficiency of our system and may also contribute to greater stability over time by absorbing risks that other institutions would not absorb, they may also introduce some uncertainty into market dynamics in conditions of stress.