To regulate or not? A look at Hedge funds

The decision to regulate or not regulate hedge funds is a tough one. On one hand is the view that more regulation is needed since the funds have grown so large and often take large risks. The big fear in this camp that a "blow-up" could lead to major market declines. (Sort of the LTCM scenario).

On the other hand is the view that by their very nature hedge funds are difficult to regulate and regulation would lower returns and the nations that regulate would lose hedge funds to those nations that do not regulate. For instance, it has been reported that an amazing 80% of hedge funds are already registered in the Cayman Islands and "the rate of hedge fund formation continues in Cayman at a rapid rate."

The difficulty of regulation acknowledged, US Treasury Secretary John Snow met with German officials as discussed increased Hedge fund regulation:

Latest News and Financial Information | Reuters.com:

"U.S. Treasury Secretary John Snow and German Finance Minister Hans Eichel agreed on Thursday that hedge funds bear close scrutiny but avoided saying whether they agreed tougher regulatory oversight was required.

At a brief meeting with reporters after a one-on-one session between the two, Eichel said: 'We both agree we need transparency. Whether we need more regulation, we could look at later on.'"

I am on the fence about this. Having spoken with many in the fund industry over the past year about this topic, and generally being in favor of fewer regulations, I am slightly biased towards letting hedge funds be and hoping that the increased number of hedge funds diversifies the market.

However, if pushed off the fence, I think my opposition to information asymmetries would trump my distaste for regulation and I would be pro-limited regulation.

Why? Investors should be allowed to know what they are investing in. Of course, this will take away some competitive advantages, and some funds may leave the country, but many would not. Currently with reporting problems, survivorship issues, and a "black-box" mentality that exists, there is reason to distrust what the industry is saying.

Moreover, even with increased regulation, all is not lost for the hedge fund industry. Reduced asymmetries will also increase the number of investors willing to invest. (As an analogy consider food manufacturers who are required to disclose nutritional information--and yes to extend this I realize that restaurants are not required to disclose, but given my choice, I always try to pick those that voluntarily do disclose.)

As a final point, as the minimum investments drop for some funds, the SEC will have a much stronger case for regulation as it is supposed to look out for the smaller investors.

Interestingly (and I swear it is true), I wrote this entry without wanting to be biased by what others thought. I then decided to do a web search to see what others (particularly in academia) were saying. It appears at least some others are falling on the same side of the fence:

""Originally, I was opposed to the requirement that they be registered as investment advisors," says Marshall E. Blume, professor of financial management and finance at Wharton. "But I'm not so opposed anymore. I think there are some shenanigans going on, particularly with respect to the pricing of the assets that they hold. Some of these are really exotic [securities] for which there is no market. And there are incentives for the managers to make a lot of money real quick.""

I definitely recommend the Knowledge (i.e. Wharton publication) on this issue!