The Truth about Hedge Funds

Article excerpt

Do hedge funds help or hurt the financial markets in which they operate? The highly publicized troubles of Long Term Capital Management have once again focused the attention of policymakers and the press on the hedge fund industry and the cry for its regulation. This Economic Commentary refutes some of the commonly held myths about hedge funds and examines the rationale for their regulation.

The highly publicized problems of Long Term Capital Management (LTCM) in 1998 have once again focused the attention of policymakers and the financial press on the hedge fund industry. LTCM's sudden fall from grace has made for colorful reading, in part because its principals include Nobel laureates Robert Merton and Myron Scholes. Interest was heightened by the Federal Reserve Bank of New York's involvement in coordinating LTCM's short-term rescue by IS large banks and security firms. The New York Fed later justified its participation on the grounds that "an abrupt and disorderly liquidation would have posed unacceptable risks to the American economy."1

This is not the first time, however, that policymakers have expressed concern over the role of hedge funds in financial markets.2 Critics allege that hedge funds have increased the volatility and decreased the stability of financial markets. Further, they maintain that hedge funds played a major role in the currency crises of the 1990s and contribute to the increased volatility of foreignexchange, equity, and debt markets. These claims, however, have not withstood close examination.

In this Economic Commentary, we examine some of the rationales for closer direct supervision of hedge funds. We first provide an overview of the industry, contrasting hedge funds with mutual funds; we go on to discuss the structure of hedge funds and examine their strategies. We conclude by describing the current regulatory environment for hedge funds and discussing the issue of increased regulatory scrutiny.

A Primer on Hedge Funds

Hedge funds and mutual funds, both private investment pools, are organized under the Investment Company Act of 1940 and regulated under the Securities Act of 1933 and the Securities Exchange Act of 1934. However, private investment pools that limit ownership to 100 high-net-worth investors and do not issue securities to the public are exempted from such regulations.3 The National Securities Markets Improvement Act of 1996 removed the restriction on the number of qualified investors for hedge funds. However, it is common practice among hedge funds to limit the number of investors to 500 in order to be considered a private offering under the Securities Act. Qualified investors include individuals with at least $5 million in capital and institutional investors (such as mutual funds, pension funds, and college endowment funds) with at least $25 million in capital.

Hedge funds are further distinguished from mutual funds by the following:

Hedge funds are not limited in the financial assets they may hold, including derivative securities.

Hedge funds face no restrictions on short sales.

Hedge funds may be highly leveraged.

Fund managers' compensation is based on the fund's financial performance.

Hedge funds may limit withdrawals.

The first hedge fund, begun by Alfred Winslow Jones in 1949, was a marketneutral fund.4 Jones' strategy was to buy securities that were undervalued and to sell short others (see table I ). The securities sold short provided a natural hedge against market risk and provided Jones with some of the funding for his portfolio. Today, in addition to marketneutral funds, which structure their portfolios to eliminate gains and losses resulting from general movements, there are seven other types of hedge funds (defined by their investment strategy) operating domestically and abroad. These fund strategies are summarized in table 2. As hedge funds do not report financial data to the SEC, the exact number of funds in existence and their total assets managed can only be estimated. …