Costs Without Benefits: Should Hedge Funds be Regulated?

Hedge funds have taken some undeserved blame for the 2008 financial crisis, and many government regulators and politicians have mentioned regulating hedge funds. On November 13, the House Committee on Oversight and Government Reform held a four-hour hearing with five of the most successful hedge fund managers in the United States. Part of that hearing focused on regulation of the hedge fund industry. George Soros, present at that hearing, recommended greater regulation of the financial system to prevent asset bubbles, but warned that regulating hedge funds would hurt the economy by putting some hedge funds out of business. Can any purpose be served by regulating hedge funds, and if so will the benefits outweigh the costs?

Hedge funds are investment vehicles that pool investors’ money and invest in a variety of financial instruments. The principal differences between a hedge fund and a mutual fund are (1) that hedge funds only accept investments from a limited number of investors to avoid being regulated like a mutual fund – this limit is usually 100 investors or less, (2) because of this investor limit, the investors in hedge funds are not public or retail investors but very wealthy individuals or institutional investors like banks, insurance companies, pension funds, and college and university endowment funds, and (3) hedge funds offer a wide spectrum of investments including investments in illiquid securities and interests, sophisticated strategies that capitalize on directional bets on the market or segments of the market (such as capitalizing on a declining market by shorting stocks), and sophisticated and often complex strategies to exploit inefficiencies or perceived inefficiencies in the pricing of securities. Also, unlike open-end mutual funds, investors in hedge funds usually cannot redeem their investments at any time, but must comply with the hedge fund agreements as to when the investors can request liquidity.

During the recent financial crisis, the criticism of hedge funds was principally directed at their leverage, and the effects of their de-leveraging. That is, hedge funds until recently could borrow funds from banks based in the assets in the hedge fund. Thus, a bank might lend a few to several times the actual invested amount in a hedge fund. The hedge fund managers would then invest that borrowed money along with the invested funds to enhance returns. The borrowed money would be paid back to the bank plus a fixed interest rate, and if the hedge fund earned a return in excess of what it had to pay the bank, any excess return over the cost of the bank debt redounded to the hedge fund investors and managers. However, leverage of a few to several times the invested capital can and did lead to swift and dramatic losses if the hedge fund’s strategies are wrongly positioned for the moves of the market. In that event, which did occur during the volative market moves of 2008, the banks usually will call in some portion of the loaned funds to reduce the bank’s risk of repayment. These call-ins of bank debt are akin to margin calls on a retail investor. The calling in of loans for repayment in the hedge fund industry is usually not a problem unless it is done on a large scale, and then hedge funds are forced to liquidate assets to raise cash to repay the banks. If many hedge funds in the same market niches are required to repay the banks at approximately the same time, then the sudden flood of sell orders on assets in that market niche can quickly become a death spiral on assets values when there are few buyers and lots of sellers.

If major financial institutions are also holding those types of assets on their books at the time of massive selling by hedge funds, then the values of the financial institutions’ assets suffers the same precipitous decline as the value of those assets on the books of the hedge funds. That is what happened in the mortgage-backed securities market and the structured products market this year, and caused many large financial institutions to become technically insolvent because their asset values dropped below their aggregate liabilities. Many hedge funds failed during this period of time, leaving their investors with claims of just pennies on the dollar.

Can this leverage risk be attenuated with regulation, and is that beneficial to the economy at large? The risk of over-leveraging could be addressed by the SEC simply prohibiting leverage beyond certain ratios. However, the SEC does not know the optimal level of leverage for any particular assets class. If the SEC regulated in this area, it would be guessing at the right ratios, when the ratios appropriate in any given situation might differ and change over time. For instance, should real estate assets be leveraged at 3-to-1 or 1-to-1, and that might depend on the interest rates in the economy and the general level of financing availability. If the SEC is guessing on real estate assets, what about real estate investment trusts, mortgage-backed securities, or publicly-traded debt instruments on automobile companies? Since no regulator is going to know either what is beneficial to the hedge fund’s investors nor what is beneficial for the economy either, it is most likely best for the SEC to not regulate in this area. The SEC or any regulator is likely to do more harm than good and chill or prohibit value-enhancing voluntary transactions among financial actors.

Hedge funds are managed usually under the 2-and-20 rule, which is that hedge fund managers get a 2% management fee each year on committed capital, and they receive 20% of the profits of the fund (known as the “carried interest” or the “carry”) once a certain rate of return has been earned for the investors (known as the “hurdle rate”). Sometimes the management fee is offset against the success fee (the 20%). Aside from Congress considering taxing the 20% carry at ordinary income rates – it is currently taxed at a capital gain rate – does the regulation of fees confer any benefits to investors or to the economy at large? The answer here is clearly no; these sophisticated investors are on an equal footing with the hedge fund managers and can easily protect their own interests. They can ask for that information before investing and do not need the protection of the securities laws to provide an effective mechanism for establishing their rights.

The usual regulator initiative with regard to funds and investment advisors (which many hedge fund managers are anyway) is federal or state mandated disclosure of fees and the nature of the hedge fund’s business, who are its principals, and whether they have any criminal convictions or indictments. Would the wealthy and sophisticated investors in hedge funds benefit by greater disclosure of the fund and its activities? That is doubtful, because these investors are so sophisticated that they can usually obtain the information they want by requiring it before investing, and insisting on terms in the hedge fund agreement to provide that information to investors on an ongoing basis. Accordingly, filing disclosure documents with the SEC under the SEC’s usual rigid approach to disclosure documents would increase costs on hedge funds and provide little if any benefit to the investors in such funds.

Thus, because of the limited number of sophisticated investors in hedge funds, there is no benefit to those investors to regulation of such funds. Furthermore, there is no discernible benefit to the economy or to financial markets for hedge funds to file disclosure documents about their processes and management with the SEC. Hedge funds, like any other investor, already to file mandated disclosure documents with the SEC if the funds take a greater than 5% position in any publicly-traded company. Other than that requirement, regulating hedge funds will be a costly exercise for all parties to hedge fund transactions and will provide no discernible benefit to any such party or investors at large. Accordingly, regulating hedge funds would result in costs without benefits.