In the investing world, it can be a short three-step walk from problem to new regulation. First, a problem is uncovered. Next, "victims" or "losers" are identified. Then, regulations and legal remedies are proposed.

So when a hedge fund run by Amaranth Advisors blew up and made headlines last week — ultimately dropping about 65 percent of its value on losses in natural gas — it was a short walk to legislators taking another whack at regulating hedge funds.

I say "another" because regulators had hoped to lasso the hedge-fund industry this year, creating rules that required these private investment pools to register as investment advisers. A court overturned the rule, but the Securities and Exchange Commission still wants to rope in hedge-fund managers.

Amaranth created another public-relations opportunity for the regulators.

The problem is that widespread hedge-fund regulation is both impractical and unnecessary, especially when there are easy solutions that could keep ordinary consumers out of harm's way without saddling enforcement officials with a new and enormous burden.

To see why that is, let's delve into the world of hedge funds in general and Amaranth in particular.

Hedge funds are investment pools for institutional investors and "high net worth" individuals. They come in any number of flavors, but are most recognized for using strategies that the typical mutual fund isn't allowed to, placing bets against the market or borrowing money to heighten the power of savvy trades. The idea is that "hedging" the market will enable these funds to make money no matter which way the market moves.

In exchange for that kind of constant earnings potential, investors pay a lot, starting with the perils of investing in an unregulated security pool and ending with the 20 percent of any profits that goes to the manager.

Today, there is more than $1 trillion invested in more than 8,000 hedge funds. While funds once required massive amounts of money to invest, today there are issues that allow investors in for as little as $50,000.

When a hedge fund blows up, it makes headlines for two big reasons. The first is that many observers fear another situation like Long Term Capital Management, a hedge fund that imploded in 1998, necessitating a Federal Reserve bailout to protect banks that were at risk from the losses. It also makes news because those institutional investors sometimes represent very real people.

The San Diego County Employees Retirement Association, for example, invested $175 million in Amaranth last year, according to Alpha magazine. If the investment is still in place — and hedge funds have highly restricted redemptions — it's lost over $100 million this year. By itself, that won't sink a $7 billion pension fund, but it will raise the hackles of some politicians who fear their own constituents might be next.

So when the Amaranth story broke, there was a renewed hue and cry for regulation. That call is misplaced, because regulation won't stop the problem.

In fact, if the regulation of mutual funds is an indication (and it is), scandals get uncovered when whistle blowers alert regulators and not by the mere presence of regulation. Moreover, regulators scarcely have the personnel or budget to regulate ordinary funds.

Besides, Amaranth was no fraud; it was just bad management.

Waste of resources

Deploying scarce regulatory resources to monitor hedge funds means that the government is trying to protect investors who, truth be told, should know better. It redeploys resources that should be used on investors who don't.

Hedge funds are the domain of "accredited investors," a status with a minimum standard of $1 million net worth and $200,000 in income. The big hedge funds are the land of institutions, which hire well-paid consultants to check out the funds and know what they're getting into.

And while there are situations where, say, a small-town schoolteacher sits on the investment board of the local pension investment committee and wants to go hedge fund after reading a glowing article in a business publication, regulation won't protect people who act stupid (and even the small-timers tend to hire consultants to pick hedge funds).

As for individual investors, the solution for hedge-fund protection is simple: raise and change the accredited investor standards, going beyond net worth or paycheck size to create a rule requiring that no more than 10 percent of that asset total can go into a single hedge fund, with no more than 35 percent of all assets placed in hedge funds.

This would force hedge funds to "know the customer" that much better, would diversify investors and protect them from their greedy tendencies and would allow the regulators to keep the bulk of their focus on those investments that are common tools for average investors.

It won't clean up Amaranth, or the next hedge fund blow-up, but neither will the regulation of hedge funds.

Copyright (c) 2006 MarketWatch, Inc.