Hedge fund regulation has long been a subject of debate, with the SEC pushing for tighter restrictions and managers doing all they can to avoid it. Both stances are understandable. Managers are known for their ambiguity. They provide just enough information to investors, but usually leave the tedious information about specific strategy details and asset allocation to themselves. The federal government and SEC claim to be looking out for the investor.
After the dozens of crimes involving hedge fund fraud over the last decade and the millions of dollars bilked from investors, the SEC rationalizes that somebody should step in to quell this epidemic of smooth talking swindlers. For that matter, even reputable names like the one time Bear Stearns don’t always adhere to the best practices.
Two hedge fund managers at Bear who are responsible for the implosion of two billion dollar funds swore to investors that the fund was doing fantastic. Performance reports showed no worries. Only internal emails to each other highlighted the scare and warned of the future demise of the fund. Could tighter regulation have prevented that problem? The SEC says yes.
In 2006, the SEC passed a rule that all hedge funds would have to register as investment advisors, only to have it overturned by the federal government. Dozens of high profile hedge funds wrote letters explaining why hedge fund regulation would result in more bad than good and that the SEC was overstepping the boundaries of its jurisdiction. Others argued that investors in hedge funds are highly sophisticated and they don’t need protecting. There are already rules set in place as to who may invest in a hedge fund, and as long as the investor knows there is risk involved, it is ultimately his decision.
Federalism then forced the arguments into the state’s hands, while some states pushed for tighter regulations and others like New York and Connecticut opted against it. After California called for stricter measures, it was ultimately overturned earlier this year after many prominent hedge funds expressed concerns that regulations would only push hedge funders into other states while taking their vast incomes and purchasing power with them.
One of the reasons that managers oppose greater transparency is the need for secrecy in their strategy. Since hedge funds may entertain a wide variety of strategies and combination of strategies, managers are very reluctant to let others view their moneymaker. Once a strategy is exposed, other managers may follow suit leading to the drying up of the waterhole so to speak. Particular strategies are the product of the brilliance behind the manager and other integral members of the staff and therefore do not want to be given up.
Also, since most hedge fund strategies are so complex, many investors might not understand the entirety of it anyways. Why disclose something that would only aid in confusion? Another reason is the obvious need for the non-disclosure of price. Buyers typically want to buy at the price you paid for it, not under the circumstances where you are going to make a killing off what they pay.
Size also correlates to the amount of transparency involved. Smaller, newer funds may have to disclose more information in order to attract capital and new investors. They may have to be entirely open on where investments are going and how they are allocating the cash. Larger, more established hedge funds are a different story. They may have an abundance of capital and are therefore not concerned with attracting new investors. If this is the case and the money is already locked up, they may become very secretive and start investing in riskier securities or use outlandish strategies to start reaping high returns in a short time frame.
But what is the investor’s role in all of this? Do they typically side with the openness pushed for by the SEC or the hush hush tendencies of hedge fund managers? One might think this is an obvious answer, with investors wanting to know exactly where their millions are going. But recent trends show just the opposite. Apparently, when it comes to hedge funds, trust is the key word.
Managers that have worked in the industry for years generally have a vast number of contacts and have gained the trust of many affluent individuals. I doubt that John Paulson, the man whose hedge fund has returned billions for investors, has to sit down and convince people of his accolades. If trust is directly related to experience, then established managers should have no problem recruiting investors.
Regulation or not, it is ultimately up to the investor to make the final decision. The SEC will never stop funds from collapsing, no matter how much light they shed on them. If hedge funds could promise massive returns and no losses, then everybody would invest. Reward only comes with risk. It always shocks me when investors are dismayed over an asset freeze. This is a real and distinct possibility that you knew could possibly happen going into the fund. Not that I think it’s fair or right. Keeping someone from their own money seems somewhat illogical. But still, it’s a pretty common practice. Some hedge funders just want to ride a bad wave out in the market and want to focus on strategy rather than dealing with withdraws and the liquidity crunch that would ensue. Unfortunately, a lot of the times, a redemption freeze is a precursor to the fund’s closing. These are things to think about. An investor in a hedge fund holds a certain responsibility.
Some choose to spend the money and perform a due diligence check. This is a smart idea and will raise any red flags in the manager’s past. Others choose to bypass this slightly expensive process and take faith in the manager. Whatever sleuthing they choose to participate in, the investor is always going to be exposed to risk. But the lure of the $3 trillion hedge fund industry and the very real possibility of massive returns will always ensure that there is no shortage in interest.