|
Knowledge@Wharton is an online business publication presenting business news, analysis
and research to corporate executives, entrepreneurs, policy makers and academics. For complete versions of these and other articles, visit this free site at
http://knowledge.wharton.upenn.edu
The Perils of Hedge Fund Regulation
To many investors, hedge funds seem
like an oasis of positive returns in the
current desert-like environment of poor
returns. Whether this is true is debatable.
But two trends have made the regulation
of hedge funds – which so far
have been very lightly regulated – a hot
topic. One is the increasing availability
of hedge fund products to a broader
audience than previously had access to
this asset class. The other is the barrage
of news reports focused on hedge fund
fraud and blowups, which directly or
indirectly raise the idea that regulation
might provide a useful fix.
So should hedge funds be regulated?
Absolutely not, argue Wharton faculty
members. Not only should funds not be
regulated, they say, but to do so would
threaten the core of the industry itself.
"The important issue that hasn't
been much discussed publicly is the
potential implications for the industry
if hedge funds do reach a broader market,"
says Richard J. Herring, finance
professor at Wharton and co-director
of the Wharton Financial Institutions
Center. "It's easy to understand the
pressures to make them available to a
wider range of clients, but once the
issue of protecting consumers enters
into the discussion, the regulatory
game shifts in a major way."
And that would be an irrevocable
mistake. "Regulation is in some sense
incompatible with the fundamental
role and character of hedge funds,"
adds Herring, because "hedge funds are
designed by law [to operate] with maximum
flexibility."
Hedge funds occupy an important
niche in the markets. They provide liquidity
to the capital markets and take
speculative positions, an increasingly
significant role as banks have shuttered
or wound down their high-flying pro-prietary-
trading desks. For investors,
hedge funds can also serve a risk management
purpose since their returns
are often uncorrelated to those in
the equity and fixed-income markets.
These funds are able to achieve the
returns they do precisely because they
operate without many of the financial
constraints that would otherwise hobble
their complicated strategies.
Like mutual funds, hedge funds are
pools of money invested in financial
instruments. Unlike mutual funds, they
do not trade on exchanges, they are
not registered with the Securities and
Exchange Commission, they are
subject to few regulations, and their
investors are not extended the same
consumer-protection benefits that
are given to investors in mutual funds
and other entities that fall under the
1940 Investment Company Act. In
addition, hedge funds frequently
employ leverage and use sophisticated
trading strategies that ordinary investors
do not understand.
In short, investing in hedge funds
can be like playing Russian roulette.
This blatant risk has historically been
addressed by limiting hedge funds to
accredited investors – wealthy individuals
with at least $1 million in assets and
institutions with $5 million – and by
stipulating minimum-investment
thresholds of, say, half a million dollars.
"Congress originally was wise to limit
the investor pool to those wealthy
enough to be able to make judgments on
their own, without the help of SEC regulations,"
says Wharton Finance Professor
Richard Marston, director of the George
Weiss Center for International Financial
Research. The reasoning is that these individuals
and institutions can perform
the necessary due diligence themselves
and can take on large risks. "The only issue
is whether or not that continues to be
the case," he notes.
This lack of regulation makes sense
when investors are wealthy but doesn't
when people with lesser means enter
the market. "I don't think people really
get terribly upset when somebody with
$10 million loses a couple million dollars,"
says Marshall E. Blume, finance
professor and director of the Rodney L.
White Center for Financial Research at
Wharton. "But once average investors
get hurt, as they will, all bets are off."
The threat is that broadening the investor
pool will inevitably lead to the
regulation of hedge funds.
To read the rest of this article, visit
http://knowledge.wharton.upenn.edu/articles.cfm?catid=1&articleid=513
|
