New York (HedgeCo.Net) The Dodd-Frank law that was enacted after the financial crisis in the last decade was intended to curb risks taken by the likes of banks and insurance companies and sweeping changes to the hedge fund industry. The general goal was to protect the public from two things: organizations that are too big to fail and fraudulent advisors like Bernie Madoff.

Two recent pieces from the Wall Street Journal begged the question of whether or not Dodd-Frank has also had an unforeseen impact on hedge funds. The first article was an op-ed written by Steve Schwarzman, the founder of Blackstone. In this piece, Mr. Schwarzman warned that the next financial crisis will be due to government regulation and not Wall Street. This sentiment was echoed by noted economist Nouriel Roubini. What these two experts pointed out is that Dodd-Frank has caused banks to hold more securities in order to meet liquidity requirements and thus the amount of trading activity is down. If there is a meltdown in the credit markets, these liquidity requirements will limit what banks can do and it will create a market where there are only sellers of debt instruments and no buyers.

The second piece was in regard to hedge funds making bets on the outcomes of litigation cases. This particular article was pointing out how hedge funds were on the wrong side of some big cases in the past year, but it also pointed out how hedge funds were looking for opportunities anywhere they can find them given the low number of defaults and the low interest rate environment. There was a specific quote at the end of the article that garnered the attention of this writer.
“There’s a lot of money chasing very few ideas right now, many of which are very binary in their outcomes,” said Kevin Starke, an analyst at research firm CRT Capital Group LLC.

With these two articles in mind, the question became, “Has Dodd-Frank impacted the performance of hedge funds?” Trading activity on the markets is down from where it was during and immediately after the financial crisis and they continue to trend downward. With more money than ever allocated to stocks and the bullish phase we have been in for the last six years, you would think trading activity would be trending higher.

A lot of hedge fund managers look at volume and money flow to make trading decisions and they can also use it to form their overall market view. When there is less and less trading activity, the indicators may not be as reliable as they used to be.
We knew the law would impact hedge funds from a regulatory and compliance standpoint, but it may be having the unintended consequence of hurting hedge fund performance. At least I would hope it was unintended because the more wealth that is created and protected by hedge funds, the more tax revenue that is collected by the government. And while many politicians take their cheap shots at hedge funds and hedge fund managers, the fact is hedge funds inject a lot of capital in to the markets. If there is a liquidity crisis in our future, hedge fund managers may be the biggest source of capital to keep the markets from locking up.

Rick Pendergraft
Research Analyst
HedgeCoVest