NEW YORK (HedgeWorld.com)–Low long-term interest rates worldwide are driving capital to private equity and hedge funds in search of above-average returns, but the result may be losses and a temporary shrinkage of the hedge fund industry, Federal Reserve chairman Alan Greenspan told the International Monetary Conference in Beijing, China.

“But so long as banks and other lenders to these ventures are managing their credit risks effectively, this necessary adjustment should not pose a threat to financial stability,” he said, adding that hedge funds and new financial products also have contributed to financial stability by increasing market liquidity and spreading financial risk.

But hedge fund managers are devising more complex trading strategies, a development particularly evident in the proliferation of collateralized debt obligations, he said. The models used to price and hedge these instruments are untested, he warned.

“I have no doubt that 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,” he said.

While these efforts enhance market efficiency, the low-lying fruit has already been picked and a significant number of strategies are destined to prove disappointing, a point seemingly confirmed by recent data on hedge fund returns, he said.

His speech, sent to Beijing via satellite Monday night, started by discussing explanations of why long-term rates have declined despite the Fed’s boosting of short-term rates over the past 12 months–a situation he has described as a conundrum.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.