Wednesday, October 27, 2004

SEC to regulate hedge funds

In a controversial ruling, the SEC decided by a 3-2 vote to begin regulating hedge funds.

Prior to this, hedge funds have been largely unregulated. Since the funds are targeted at wealthy investors and institutions, it has been widely held that the SEC need not worry itself with the funds. However, as the classic Bob Dylan song says, “The times they are a changing.”

The arguments against regulation:

The basic argument against regulation is that the investors in the funds are wealthy and know what they are doing and do not need hand-holding. For instance the LA Times reports:
“Federal Reserve Chairman Alan Greenspan, Treasury Secretary John W. Snow and some members of Congress have argued that oversight isn't necessary for an industry catering to an elite clientele well aware of any risks.”

Interestingly, travel and circumstance have led me to speak with several hedge fund executives in the past month and from their perspective regulation is not only unnecessary, but also detrimental to both returns (costs have to be borne by someone) and risks as investors will now have less incentive to monitor the funds.

So why the registration now after years of nothing? There are several explanations:
  1. 1. Hedge funds are hot. It has been estimated that there are now nearly 7000 of these funds controlling over $800 billion. While these funds are designed for wealthy investors, there is a fear at the SEC that indirectly, shares are being held by smaller investors as well.,,8210-1326889,00.html
  2. Hedge funds have grown significantly (up nearly three-fold in the past five years by some estimates) and this growth may have broader implications for market stability (this is sort of the Long Term Capital Management explanation—where regulators fear that the collapse of a hedge fund could lead to market-wide price declines.
  3. The lack of disclosure opens the door for potential fraud. From the SEC: Commission's inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct. The Commission typically is able to take action with respect to fraud and other misconduct only after it receives relevant information from third parties, and frequently only after significant losses have occurred.”

It should be noted that the SEC rule itself is not overtly onerous; many fear that it is a first step in the door for regulators.

Again from the LA Times:

“Under the new SEC rule, hedge funds must register their names, addresses and
other information with the agency, including detailing the value of their
assets. Regulators will be able to review the funds' books….The new
requirements, scheduled to take effect in February 2006, will apply to hedge
funds with at least $25 million in assets and 15 U.S. clients.”

My guess is that it will not be as bad as those in the industry fear. Sure their costs will increase slightly, but they will also get increased exposure and it may be easier to get investors (although of late that has not been a problem for most hedge funds).

* As an aside, if you are looking for employment in the hedge fund industry, compliance may be a way to get a job.

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