Up in the sky, it's ... the spectacle of plummeting hedge funds, burdened by new scrutiny and weakening returns.

Byline: Rana Foroohar

When Sumner Redstone, the much-respected head of media conglomerate Viacom, unceremoniously booted toothy megastar Tom Cruise from his perch at Paramount earlier this month, there was plenty of talk about how studios are finally looking to offload the risk of super expensive actors, who often milk millions from a film before producers can take their own cuts. Less well covered were the new players looking to pick up that risk--namely, hedge funds. While it's unclear whether a reported $100 million offer of support from hedge funds to Cruise's production company will actually materialize, hedge funds are already backing films in a big way. Larry Ulman, head of the entertainment practice at L.A. law firm Gibson, Dunn & Crutcher, estimates that there's as much as $4 billion in hedge-fund money in Hollywood, and the number is growing. "Whether or not they can do better here than the studios themselves is another question," says Ulman.

The very fact that they are willing to try their hand at such a notoriously capricious business says a lot about the evolution of the hedge-fund industry itself. Once a niche investment for ultra wealthy individuals, hedge funds have in the last five years gone mainstream, with pension funds, endowments and other big institutional investors pouring money into them. The Hennessee Group, a New York-based investment adviser that tracks hedge funds, estimates that the global market has grown from $130 billion in 1997 to $1.5 trillion today, with 56 percent of that money held by companies and institutions. That means that if you have money in pension funds, mutual funds or any number of high-profile public companies, part of your future is invested in hedge-fund managers, a breed now desperate enough to seek returns in actor-run movie studios.

The upshot is clear: the party is over. After the dot-com bubble collapsed, hedge funds (which tend to bet against conventional market wisdom) were one of the few investments that still offered the promise of double-digit returns. The problem is that as more and more investors have gotten into them, their power has diminished. "Call it the 'commoditization of hedge funds'," says Peter D'Amario, a consultant with the Connecticut-based financial-research firm Greenwich Associates. The bottom line is that returns have been shrinking for the last few years, as more funds chase fewer market opportunities.

The mainstreaming of hedge funds has resulted in two important party-popping trends. First, there's been a worldwide push toward greater regulation and rating of these largely opaque investments, so that small investors won't get burned. Of course, it was in many ways the lack of regulation--including the ability to engage in complicated options, futures and swap deals that are forbidden to mutual funds--that gives hedge funds their power to mitigate risk. If they are treated like any other investment, their power, and their returns, will continue to diminish. Though a U.S. Securities and Exchange Commission rule requiring hedge funds to register was overturned this summer, it is now examining new proposals, including a possible increase in the minimum-asset requirements for hedge-fund investors. As SEC Chairman Christopher Cox told Congress in July, the existing minimum, of at least $1 million in net worth, seems hopelessly outdated when "in California, the median home price is well over one-half-million dollars."

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