Should Hedge Funds Be Regulated?
Hedge funds: Background Issues and Controversies
Hedge funds are simply 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. Even some hedge fund managers do provide a breakdown
of the 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”
Such charges 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 said fraud happens in other industries, pointing to the case
of Enron, Arthur Anderson, or World Com to name a few. 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 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 hedge funds 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
The accelerated growth of hedge funds comes from partly two reasons;
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 or the MSCI. As long as hedge funds continue to provide
absolute returns to investors, its growth is all but inescapable.
Hedge fund Managers
Part of the reason why hedge funds are doing well, comes from 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 market trend. Other hedge fund managers apply advanced asset allocation
techniques through analysis of traditional data in combination with 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 only destroy or at least reduce
the natural setting under which hedge funds operate.
Market forces would always play the role of the ultimate 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 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.
Hedge fund current regulations have served its purpose well, 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 should
be left alone.
Paul Oranika
Editor-in Chief
Hedgeco.net
Email: Editor@hedgeco.net
Related Reading:
 What
is a Hedge fund?
Hedge
Fund Assets Projected to Grow by 20% in 2004
An
Appraisal Of Asia-Pacific Fund Investment Market
Mutual
Fund Scandal Fails To Derail Gains By Stock Funds
|
