Hedge funds are getting rich, but who is really taking the risk?

by Thomas Desplinter February 27 2008, 09:25

There have been a number of calls lately for increased regulation of the hedge fund industry, however, the Bush Administration has said that no new regulations are necessary.  Despite the rapid growth of the industry and the increasingly large risks hedge funds are taking, the recently released report by the President’s Working Group on Financial Markets, which was led by the Treasury Department, did not call for any new regulations, but instead called for a set of principles to be implemented, such as accurate disclosures by fund managers and more due diligence by creditors.  [1] Nevertheless, the Group of Seven (G7), of which the United States is a member and comprises the seven wealthiest countries in the world, vowed to continue looking into what new measures should be taken in order to impose stricter scrutiny over the risks being taken by hedge funds, and the risks they pose to the global economy. [2]

The total assets under management in the hedge fund industry rose in 2006 to nearly $1.4 trillion, up 29% from the year before, with a record $126.5 billion of new money being invested. [3] Hedge funds, which are investment pools for wealthy individuals and institutional investors such as pension funds and insurance companies, have become increasingly popular because their private nature excludes them from the strict oversight the Securities Exchange Commission (SEC) must give to more public investment instruments, such as mutual funds.  [4] The touchstone of these regulations is disclosure, and the logic behind exempting hedge funds from the same reporting requirements is that those investing in hedge funds are more sophisticated market players who know the risks they are taking and don’t need the government’s intervention or protection.  [5]

The problem is that the risks are so large that they are not always limited to those taking them.  The most well-known example is the meltdown of the giant hedge fund Long Term Capital Management (LTCM) in 1998, which lost $4 billion dollars overnight, but due to its highly leveraged positions, the loss had a conceptual effect on the economy of closer to $1.25 trillion, which threatened the stability of the global marketplace. [6] This forced the Federal Reserve to orchestrate a bailout plan in order to prevent the implosion of the world economy and led to the last report by the President’s Working Group on Financial Markets in 1999.  [7] The reforms that were actually implemented were few, however, and just last fall, Amaranth Advisors LLC lost $6.4 billion after making large bets in the natural gas markets, prompting the latest round of calls for new regulations. [8]

The impact on the global markets from the Amaranth disaster was not as drastic as LTCM because, even though Amaranth lost more of its capital than LTCM, it was far less levered.  [9] However, while the real danger may lie in a fund’s ability to ignore the lessons of LTCM and Amaranth by over-leveraging itself, many of the new regulations that have been proposed are designed to protect the investor by forcing the funds to disclose any changes in its strategy. [10] This would prevent some of the larger funds from employing different, riskier strategies without informing investors exactly how much risk is being taken.  [11] Defending the report and the administration's stance that new regulations are unnecessary, Treasury Secretary Hank Paulson cautioned that the principles laid out were not meant to prevent hedge funds from failing, saying that, “As long as we have investors out there, some are going to do better than others and some are going to fail … [w]hat we're emphasizing is market discipline and transparency.” [12]

This was unacceptable to Connecticut Attorney General Richard Blumenthal, whose state is home to many top funds, and who criticized the report by saying that, "These vague recommendations lack substance and specifics, making them unenforceable. In a perfect world, everyone would already follow these guidelines. But in the real world we need real protections.” [13] The G7 issued its own call for reform, requesting a study of the hedge fund industry for its next meeting in May to be conducted by the Financial Stability Forum, and issuing a statement saying, “Given the strong growth of the hedge fund industry and the instruments they trade, we need to be vigilant. The assessment of potential systemic and operational risks associated with these activities has become more complex and challenging." [14] While this is less of a push than had initially been indicated by German Finance Minister Peer Steinbrueck, who put the item on the agenda, it showed that Germany was finding common ground with the United States and Great Britain, two countries which have large hedge fund sectors. [15]

Some of the proposed regulations though are even being met with opposition from those who they are designed to protect, including the SEC’s effort to raise the minimum threshold required for an individual to invest in a hedge fund from $1 million to $2.5 million. [16] The commission explained that the proposal was meant to “define a new category of accredited investor, which is called an 'accredited natural person,' which is designed to help ensure that investors in these types of funds are capable of evaluating and bearing the risks of their investments.”[17] The proposal was roundly criticized, however, as discriminatory towards those who aren’t extremely wealthy by restricting their investment options.  [18]

Further, smaller investors called for the SEC to focus more on fraud and other unfair practices in the retail market that are truly a direct cost to smaller investors. [19] That would include the latest potential scandal hovering over Wall Street, in which several of the top banks have been asked to submit information to investigators looking into allegations of "front running," the practice whereby traders improperly benefit from their knowledge of the trades their mutual fund or institutional clients plan on making by trading in front of a future order. [20] Even if they don’t trade in front of their clients, they can also pass on the information to hedge funds that give them a lot of business, which would still drive up the price for the mutual fund, and in the end, the small investor. [21]

As hedge funds continue to increase the amount of risk they are taking, the calls for stricter regulations will continue to become louder.  However, until there is real enforcement beyond principles of self-restraint, the real risk will continue to be born by the global economy, and hedge funds will continue to get the reward. 

[1] No big hedge fund risk to markets seen, CNNMoney.com, February 23 2007, available at http://money.cnn.com/2007/02/23/markets/hedge_funds.reut/index.htm

[2] G7: Call for hedge fund scrutiny, CNNMoney.com, February 11 2007, available at http://money.cnn.com/2007/02/11/news/international/g7_hedgefunds.reut/index.htm?postversion=2007021108

[3] Grace Wong, Hedge Funds Bring in the money, CNNMoney.com, January 18 2007, available at http://money.cnn.com/2007/01/18/markets/hedge_flows/index.htm

[4] Id.

[5] Bethany McLean, SEC slammed over hedge fund 'wealth' test, Fortune, February 11, 2007, available at http://money.cnn.com/2007/02/11/magazines/fortune/sec.fortune/index.htm?postversion=2007021117

[6] No big hedge fund risk to markets seen, CNNMoney.com, February 23 2007, available at http://money.cnn.com/2007/02/23/markets/hedge_funds.reut/index.htm

[7] Andy Serwer, Shrugging off Amaranth, Fortune, October 3 2006, available at http://money.cnn.com/magazines/fortune/fortune_archive/2006/10/16/8390289/index.htm

[8] No big hedge fund risk to markets seen, CNNMoney.com, February 23 2007, available at http://money.cnn.com/2007/02/23/markets/hedge_funds.reut/index.htm

[9]  Andy Serwer, Shrugging off Amaranth, Fortune, October 3 2006, available at http://money.cnn.com/magazines/fortune/fortune_archive/2006/10/16/8390289/index.htm

[10] Id.

[11] Id.

[12] No big hedge fund risk to markets seen, CNNMoney.com, February 23 2007, available at http://money.cnn.com/2007/02/23/markets/hedge_funds.reut/index.htm

[13] Id.

[14] G7: Call for hedge fund scrutiny, CNNMoney.com, February 11 2007, available at http://money.cnn.com/2007/02/11/news/international/g7_hedgefunds.reut/index.htm?postversion=2007021108

[15] Id.

[16] Bethany McLean, SEC slammed over hedge fund 'wealth' test, Fortune, February 11, 2007, available at http://money.cnn.com/2007/02/11/magazines/fortune/sec.fortune/index.htm?postversion=2007021117

[17] Id.

[18] Id.

[19] Id.

[20] Shawn Tully, SEC probes possible insider trades, Fortune, February 19, 2007, available at http://money.cnn.com/magazines/fortune/fortune_archive/2007/03/05/8401273/index.htm?cnn=yes

[21] Id.

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