A Law and Finance Analysis of Hedge Funds
Cumming, Douglas, Dai, Na, Financial Management
This paper empirically analyzes the impact of hedge .fund regulation on fund structure and performance. The data indicate restrictions on the location of key service providers and permissible distributions via wrappers" are associated with lower fund alphas, lower average monthly returns, and higher fixed fees. Furthermore, restrictions on the location of key service providers are associated with lower manipulation-proof performance measures, while wrapper distributions are associated with lower performance fees. As well, the data show standard deviations of monthly returns are lower among jurisdictions with restrictions on the location of key service providers and higher minimum capitalization requirements.
"Hedge funds are not, should not be, and will not be unregulated!!" Christopher Cox (Chairman of SEC) in testimony before the Senate Banking Committee --Wall Street Journal, June 23, 2006
In the United States, hedge funds have been essentially an unregulated investment vehicle. By 2005 hedge funds collectively accumulated over a trillion dollars in assets, while at the peak in the summer of 2008 industry estimates suggest the market grew above $2.5 trillion in assets (Ineichen and Silberstein, 2008, pp. 16-17). With over a trillion dollars of capital under management and at 5% alphas sought/promised by most hedge funds, this implies that there needs to be at least an aggregate $50 billion above systematic-risk-justified return (and more than $125 billion in excess returns in 2008). Given the implausibility of over $50 billion being readily available for hedge fund investors and managers who aim to "beat the market," it seems highly likely that many hedge fund participants will be disappointed in the future. Furthermore, the increasingly large pool of hedge fund capital under management has the potential to move other markets and impact financial stability. As a result, the tremendous growth of the hedge fund asset class and potential systemic risk has attracted regulatory attention from the US Securities and Exchange Commission (SEC). (1)
Hedge fund registration in the United States commenced only in 2006 (Partnoy and Thomas, 2007; Brav et al., 2008a, 2008b). In other countries around the world, hedge funds face stricter regulations such as minimum capital requirements, marketing restrictions, and restrictions on retail investor participation, among other things. The growth of hedge funds worldwide has led regulators to reevaluate the suitability and effectiveness of their regulatory oversight (PriceWaterhouseCoopers, 2006, 2007). How has hedge fund regulation impacted hedge fund structure and performance?
The purpose of this study is to facilitate an understanding of the impact of hedge fund regulation on fund governance and performance. We measure fund performance along a variety of different metrics including a multifactor alpha (Fung and Hsieh, 2004), a manipulation-proof performance measure (MPPM) (Goetzmann et al., 2007) (as an alternative to the Sharpe ratio, which can be manipulated), and average monthly returns. With regard to fund structure, we focus on management and performance fees since hedge funds are best defined as a compensation scheme for a pool of money to be collectively managed and invested on behalf of the capital providers (Hodder and Jackwerth, 2007). (2)
In theory, there is an ambiguous correlation between hedge fund regulation and hedge fund structure and performance. On one hand, a lack of regulatory oversight may give rise to fund managers that disguise investment schemes and merely capture the fees. This view is consistent with theory and evidence in Bebchuk and Fried (2003), at least in other contexts, that the compensation structure is part of the agency problem rather than its solution. For instance, suppose there are two funds managed by the same group of fund managers. One has a strategy of shorting the Standard & Poor's 500 Index (S&P) while the other has a strategy of going long on the S&P. …