On September 29 2003, the US Securities and Exchange Commission (SEC) reported on the hedge fund industry after a 15-month investigation. The most significant recommendation is for hedge fund managers to register with the SEC under the Investment Company Act of 1940.
The findings are backed by the arguments that registration will better protect less sophisticated investors, that hedge funds active trading has a negative effect on the capital markets and that registration will give the SEC insight into hedge funds’ activities.
Hedge funds are unregulated investment pools that use multiple investment strategies among various investment classes. Their investor base, includes only accredited investors (usually individuals with a net worth in excess of $1m) or sophisticated pooled money, as dictated by law.
In response to the argument in favour of registration to enhance investor protection, it is worth noting that less sophisticated investors are generally not invested in hedge funds. Hedge funds are prohibited from active marketing. Thus, any marketing information is requested by diligent investors. Moreover, the vast majority of hedge fund investments come from institutions, such as pension funds and fund of funds, which conduct extensive due diligence on investment results and styles.
It is also conceivable that investors, whom the SEC allegedly wishes to protect, may construe registration as the SEC “signing off” on the viability of a hedge fund’s investment style. Thus, requiring all funds to register may create a false sense of security, which in turn might encourage less due diligence prior to an investment decision.
Trading volume
The SEC has also argued that active trading by hedge funds has a negative impact on capital markets. But Alan Greenspan, chairman of the Federal Reserve, has noted that the volume of trading undertaken on behalf of hedge funds plays an important role in providing liquidity for the rest of the capital markets. True, the collapse of the Long Term Capital Management hedge fund, magnified by its large asset base and high leverage, did impact the financial markets negatively. However, increasing regulation of hedge funds will heighten the cost and complexity of starting new ones. Regulation could therefore lead to larger funds that can impact the market, as opposed to a diverse group of smaller funds that individually cannot impact it.
If hedge funds were registered, the SEC would need to significantly increase its staff to be able to actively monitor these funds. This is likely to be a challenge for an organisation still reeling from the after-effects of the corporate and mutual fund scandals which occurred under its watch.
Besides, hedge funds are already actively monitored on behalf of their investors in at least two ways. First, virtually all hedge funds produce yearly audited financial statements. Secondly, most funds also have administrators who handle investor subscriptions and redemptions and provide regular impartial valuations of the funds’ assets. Many institutions also use third-party risk evaluation services for more complex hedge fund strategies. These checks and balances provide a higher level of scrutiny than anything the SEC is likely to perform.
Losing agility
Registration is not a particularly big deal for managers. The real danger is that once regulation starts, it is likely to increase. Hedge funds are successful in part because they are relatively nimble and able to execute complex strategies quickly. They rely heavily on proprietary research and trading strategies which have been painstakingly developed by some of the smartest people on Wall Street. If future regulation made hedge funds publicly register all holdings (the way a mutual fund does) this edge would be forfeited.
SEC chairman William Donaldson’s comments about securities pricing and their relationship with fund fees is also troubling, if viewed as a prelude to regulating how managers are compensated. The best and the brightest are not in this business for altruistic reasons. Finally, growing regulation could pose a significant barrier to entry into the industry, keeping new ideas out of the market and ultimately making the capital markets less efficient and liquid. This is not in anyone’s interest.
Erik Volfing is a principal at Grand Slam Asset Management, registered investment adviser for the Grand Slam Capital Master fund
