Issue #51

Last Update May 5, 2007

Finance Hedge Funds and Regulation by David Katz February 17, 2007  Hedge funds and related types of investment have grabbed headlines over the past few years as awareness of the enormous sums controlled by these funds have penetrated the awareness of government regulators, politicians and the general public. Hedge funds are not regulated by any of the standard U.S. regulatory agencies. A few spectacular failures, such as Amaranth and Long Term Capital, where losses amounted to many billions of dollars and threatened the stability of hedge fund lenders, have prompted intervention by the Federal Reserve and raised calls for regulation to deal with the perceived threat. At the Managed Funds Association's Network 2007 conference this month in Key Biscayne, regulation was the principal topic of panel discussions and sessions. 

The Managed Funds Association bills itself as the “global voice of the hedge fund industry” and is the industry association for hedge funds, funds of funds, trading advisors and other entities that place or trade substantial amounts in derivatives markets. It has been working closely with international, federal and state legislators and regulators in an attempt to ensure that crippling regulation be avoided, while satisfying concerns about safety and transparency. 

Hedge funds may have no more than 99 investors, and non-institutional investors must be high net worth individuals, well able to bear the risk of loss in what is by definition a high-risk, high-return trading environment. Previously, high net worth was defined as a net worth of $1 million or more. Critics feel that this number, set decades ago, is no longer a valid determinant of ability to bear risk, and have proposed changes. By and large, the hedge fund industry supports revaluing the definition of high net worth upward. The SEC has proposed changing the definition from $1 million in total net worth to $2.5 million in liquid net worth.  

Increasingly, hedge fund investors tend to be institutions such as pension funds. This has put pressure on hedge funds to provide more information to their investors, and to some degree, to move toward less risky and more predictable investments. Pension funds are required by law to manage their funds prudently, so only a small proportion of pension fund dollars find their way to hedge funds. Since pension funds have huge assets, however, even a small proportion of these assets can be substantial. 

While hedge funds are unregulated, many of their trading counterparties and lenders are. Banks and brokerage firms are heavily regulated, and provide much of the capital and market liquidity needed by the funds. The hedge fund industry foresees increasing regulation of counterparty relationships with hedge funds, while leaving the unregulated funds free to follow the risky market strategies that have made many of them so successful. In return, the hedge funds will become more transparent; that is, more information about fund activities and performance will become available on a more timely basis to investors and counterparties. The issue of transparency, however, is muddied by the restrictions on hedge fund advertising. Hedge funds fear that unless these restrictions are loosened, providing better information to their investors, and especially to the general public, will leave them open to charges of marketing to unqualified persons.

Some hedge funds have now outgrown markets in which they trade heavily, which means that market liquidity is insufficient to allow the fund to withdraw from a market that has become a loser for them; similarly, investors in these finds may find it difficult to liquidate their holdings, or can only do so at substantial loss. Making more information available about the disposition of hedge fund assets will help institutional investors and high net worth individuals better evaluate a fund's liquidity.  

The industry is awaiting the release of the report of the President's Working Group on Financial Markets, due soon. This report is the result of a mandate contained in the Hedge Fund Study Act of 2006. The MFA publishes a Sound Practices manual for hedge funds. A 2007 version will be available soon. 

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