HEDGEMONY.(The Talk of the Town)(hedge funds)

In the past five years, hedge funds have become a new power on Wall Street; the number of funds has doubled, to more than eight thousand, and the assets they control have tripled, to more than a trillion dollars. In the process, they've also become a favorite scapegoat for bad financial news, blamed for everything from inflating the housing bubble and demolishing stock prices to jacking up the price of oil. A German politician has called hedge funds "locusts" of the global economy, while William Donaldson, the former head of the S.E.C., has warned that "disaster" looms if hedge funds aren't regulated. The title of a recent column made the point nicely: "Instruments of Satan."

That's not quite what Alfred Winslow Jones had in mind when he started the first hedge fund, in 1949. Looking to make money in both up and down markets, Jones adopted a strategy of buying some stocks and selling others short. Because, at the time, mutual funds were legally barred from selling stocks short, Jones avoided government regulations by restricting participation in the fund to a small number of wealthy investors. In the half century since, hedge funds have moved a long way beyond Jones's simple "long-short" approach, and they now pursue a dizzying array of investment tactics in nearly every market in the world. But they have retained a few of the original characteristics: they're free to invest in whatever assets they want; they can buy those assets with borrowed money, using leverage to improve their returns; they generally have long "lock-up" periods for their investors' money; and, if they are successful, the people responsible earn vast fortunes.

Aside from the part about vast fortunes, that doesn't sound especially demonic. But hedge funds are easy to hate. They're secretive, rarely making public disclosures about their investments or their performance, and so are fertile terrain for fraud and incompetence. Last year, investors in a fund called the Bayou Group found out that its managers had been lying about its performance for years, having blown all the money on bad investments. Hedge funds often trade in markets--and with investment strategies--that few investors understand. Many critics suspect hedge funds of hunting in packs: conspiring to bring down ailing companies or currencies, or artificially inflating the price of commodities. Worst of all, the funds' reliance on leverage increases the scale of disaster when things go wrong. In 1998, the collapse of Long-Term Capital Management, a giant hedge fund that had made huge leveraged bets on currencies and government bonds, exacerbated a global financial crisis.

Yet hedge funds have been far more of a boon to financial markets than a bane. Markets work best when investors are drawing on diverse sources of ...