The Challenge of Hedge Fund Regulation: As Other Nations Expand Access to Hedge Funds, Should the U.S. Adopt Tighter Regulation?

By Shadab, Houman B. | Regulation, Spring 2007 | Go to article overview
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The Challenge of Hedge Fund Regulation: As Other Nations Expand Access to Hedge Funds, Should the U.S. Adopt Tighter Regulation?


Shadab, Houman B., Regulation


A "hedge fund" is a private investment vehicle that is less regulated than traditional investment companies. The name comes from the funds' traditional role as "hedges against downturns in more conventional investments. Hedge funds have historically taken investment positions that are relatively uncorrelated with broader financial markets or that maybe in opposition to broader markets. In more recent years, the term has been expanded to cover funds that employ very complex investment strategies. Once relatively obscure and, by federal statute, reserved for very wealthy investors, hedge funds today manage nearly $1.5 trillion in assets for investors that include pension funds and university endowments.

Academics, industry professionals, and regulatory authorities overwhelmingly agree that hedge funds benefit the economy by mitigating price downturns, bearing risks that others will not, making securities more liquid, and ferreting out inefficiencies. Those benefits are possible because hedge funds are subject to much less regulation than most investment companies. Compared to mutual funds, hedge funds are less restricted in their use of derivatives and leverage, and have greater incentives to do so because they are not required to disclose their strategies or holdings publicly.

Less regulation also raises important concerns about the risks the funds pose to investors and the funds' potential to destabilize the economy--the latter concern underscored by the spectacular 1998 contraction of the fund Long-Term Capital Management. Those worries have led to calls for tighter regulation or oversight.

In this article, I will show that such concerns turn out to be less substantial when considered carefully, and that hedge funds are reducing their risks for investors and other market participants. Because more regulation may reduce hedge funds' benefits to investors and the economy, policymakers should consider whether additional regulation will do more harm than good.

HEDGE FUND BASICS

Because of their different properties and practices, hedge funds as a group are best understood from a legal, not economic, perspective.

Hedge funds typically are exempt from the registration and disclosure requirements of federal securities laws, including the Securities Act of 1933, the Securities and Exchange Act of 1934 (Exchange Act), the Investment Advisers Act of 1940 (Advisers Act), and the Investment Company Act of 1940. The funds are also not prohibited from leveraged trading, short-selling, or concentrated investing. To qualify for those exemptions, hedge funds may not advertise and can only accept investments from large institutions and wealthy individuals.

REGULATIONS Despite the exemptions, hedge funds are subject to government regulation and oversight. Federal securities law prohibits hedge funds from fraud and insider trading. In 2006, 86 percent of hedge funds were registered with some regulatory body (such as the Securities and Exchange Commission or Commodity Futures Trading Commission), according to a Hennessee Hedge Fund Manager Survey. Hedge fund managers are also considered legal fiduciaries under the Advisers Act, which requires fund managers to put the interests of their funds above their personal interests.

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Hedge funds must make substantial disclosures to potential investors in order to discharge fiduciary duties and avoid running afoul of anti-fraud rules prohibiting "misleading statements" and "omissions." The Exchange Act requires hedge funds to report to the SEC any nontrivial holdings in public companies, and also all of their stock holdings on a quarterly basis if the fund has more than $100 million invested in public companies. It is also not uncommon for a fund to trade futures or commodity options contracts so as to come under the scrutiny of the CFTC, or for a fund to have 25 percent or more of its equity assets owned by a qualified employee benefit plan such that it must comply with the Employee Retirement Income Security Act (ERISA).

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