Hedge Fund Articles

Should Hedge Funds Be Regulated?

By Paul Oranika (August, 2007)

Hedge funds: Background Issues and Controversies

Hedge funds are pools of money from individuals and/or groups of qualified investors who met the requirements of the SEC. Unlike mutual funds, they do not trade on exchanges, and are not registered with the Securities and Exchange Commission; their investors are not granted the same consumer-protection benefits extended to mutual funds through the 1940 Investment Company Act. Most investors knew very little about hedge funds prior to the 1998 LTCM debacle.

Many lessons were drawn from the failure of LTCM. One of those lessons, among others, deals with the question of what levels of leverage should fund managers employ in their trading decisions. Today levels of leverage employed by fund managers have been drastically reduced; such issue which played a big role in the huge losses incurred by LTCM does not pose dangers to hedge funds today.The next controversy surrounding hedge funds seem to deal with the issue of transparency, today such controversy has run into a cul de sac, or dead end, because transparency of hedge funds have increased to the point that one can log into hedge fund information portals such as www.Hedgeco.net, and examine up to date information on hedge fund data such as short and long term returns, funds investment philosophy, or strategies used by such head fund managers. Some hedge fund managers even provide a breakdown of their funds’ current weightings.

Hedge Fund Fraud Cases

There is also the issue of hedge fund fraud; some cite a small example of fraudulent hedge fund managers who have used false reports to deceive investors while they use their assets to pursue other interests. In a recent conference of the Investment Company Institute {ICI} in Washington DC, Paul Roye, the Director of investment at the Securities and Exchange Commission {SEC} told the conference attendees about the increases in hedge fund fraud cases. As part of his opening remarks, Roye stated, “In recent years, as hedge fund assets have grown, we have also seen an unfortunate growth in hedge fund related-fraud. The Commission has had to bring far too many hedge fund fraud cases in circumstances where the losses to investors have been substantial.”  Claimants usually cite cases such as Michael Berger, Edward Jung, or David Mobley. In my previous interview with David Friedland, former President of Hedge Fund Association and also the President of Magnum U.S. Investments, based in Miami Florida, I asked him his views about hedge fund fraud and the magnitude of the problem within the hedge fund industry.  Friedland explained that fraud happens in other industries, pointing to the cases of Enron, Arthur Anderson, and World Com. In Friedland’s view, while transparency is increasing, a manager with increased transparency could still provide fraudulent documents. Friedland told me that the only reason why there is more hedge fund fraud cases in US compared to other countries is simply because 80% of the global hedge funds are located in the United States. A fact usually ignored by those using hedge fund fraud cases to make their argument for hedge fund regulation is that the ratio of fraud in the hedge fund industry is by far much smaller than that of Wall Street, which is regulated by the SEC.

Hedge Fund Regulations

Today there is so much talk about hedge fund regulations not only here in the United States, but also in England. The two leading financial market regulators, the Securities and Exchange Commission [SEC], and Financial Services Authority [FSA], seem to be slowly but steadily moving in that direction. Another financial services regulator, the Securities and Exchange Board of India [SEBI] recently made a decision to ban investments through participatory notes by unregulated entities. Hedge fund market analysts think such a move has other motives, and has nothing to do with regulation of capital markets. The new law, according to analysts, has more to do with capital account convertibility than anything. As the hedge fund industry’s growth in popularity continues year after year, the issue that has to be addressed is how such growth would impact the broader markets. According to Richard J. Herring, finance professor at Wharton and co-director of the Wharton Financial Institutions Center, “The important issue that hasn’t been much discussed publicly is the potential implications for the industry if hedge funds do reach a broader market.”Herring thinks that regulation of hedge funds would be an irrevocable mistake, explaining further that “Regulation is in some sense incompatible with the fundamental role and character of hedge funds”, adding that “hedge funds are designed by law [to operate] with maximum flexibility.”

Growth of Hedge Funds

There are two main explanations for the recent acceleration in growth within the hedge fund world: expertise, and superior performance. Hedge fund managers are among some of the brightest the financial services industry had to offer. The average return of hedge funds easily beat the average major market indexes like the S&P index and the MSCI last year. As long as hedge funds continue to provide absolute returns to investors, their growth is all but inescapable.

Hedge fund Managers

Part of the reason why hedge funds are doing well stems from the hard work and experience of many hedge fund managers, in addition to their analytical skills. Hedge fund managers are generally quick to recognize changing market trends, and they try to profit from such developing trends before other mainstream investors see such trends. Part of the reason why hedge fund managers are quick to act is because they are granted full freedom and flexibility to utilize their skills for the benefits of the fund’s investors. Through diversification, many hedge funds limit their risk exposure levels, a strategy which serves as a defense mechanism in case of a sudden change in the market. Other hedge fund managers combine the application of advanced asset allocation techniques, as well as technical analysis to decide asset allocation models which best suits their interests.

What would increased hedge fund regulations result in?

Increased regulation of hedge funds would certainly destroy, or at least reduce the natural setting under which hedge funds operate. However, in the long run, market forces will always play the role of industry regulator.  Lessons drawn from failed hedge funds also support such statements. The LTCM debacle is not the first time nor would it be the last that economic genius would fail over market reality. Even veteran investors such as George Soros lost millions of dollars during the technology meltdown a few years ago. According to published reports, Irving Fisher, the great American economist, manager of Yale’s endowment investment portfolio, lost much of the fund’s assets in the market crash of 1920s. The famous economist, John Maynard Keynes is said to have lost much of his wealth trading foreign exchange markets. Arguments about failed hedge funds should not provide a basis for additional hedge fund regulations. The hedge fund industry has done a very good job, for the most part, in regulating itself. Fraudulent hedge fund managers have been and should be prosecuted to the full extent of the law. This article maintains a view that additional regulation of hedge funds is absolutely unnecessary, it is simply another way that government bureaucrats are attempting to grab more power. Current hedge fund regulations in place have served its purpose well, and hedge funds are prospering [current hedge fund assets are in excess of US$800 billion} because of the dedication and hard work of fund managers and administrators.  The hedge fund investment process and system is not broke, and it should be left alone.

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