Hedge Fund Regulation the Purpose

Hedge Fund Regulation

The purpose of this document is to examine hedge fund regulation shift specifically as related to SEC regulations from systemic fraud fears begun in 1998 by the Failure of Long-Term Capital Management. This work will further examine the protection fears of investors resulting from the Bernie Madoff scandal and will examine as well systemic risk fears in recent financial crisis with emphasis on hedge funds. Toward these ends this work will examine online documentation available via the Internet

A 'hedge fund' is "a private investment vehicle that is less regulated than traditional investment companies." (Shadab, 2007)

Shadab explains that the hedge fund is thus named due to the role the fund plays in 'hedging' "against downturns in more conventional investments." (2007)

Historically, hedge funds have "taken investment positions that are relatively uncorrelated with broader financial markets or that may be in opposition to broader markets" (Shadab, 2007i

However, in more recent years hedge funds have also undergone expansion "to cover funds that employ very complex investment strategies." (Shadab, 2007)

Hedge funds were at one time "relatively obscure" and as well federal statute mandated that these types of funds were reserved for only the wealthiest of investors however, hedge funds presently are stated to manage "nearly $1.5 trillion in assets for investors that include pension funds and university endowments." (Shadab, 2007)

The benefits to the economy of hedge funds include mitigation of price downturns, and as well hedge funds bear risk that otherwise would not be taken and result in more liquid securities as well as "ferreting out inefficiencies." (Shadab, 2007)

These benefits are enabled due to less stringent regulation of hedge funds which are less restricted in relation to the use of derivatives and leverage and there are greater incentives to do so since they are under no disclosure requirement in terms of their strategies or holdings to the public. Hedge funds are generally exempt from the requirements of registration and disclosure under federal securities laws and this includes the Securities and Exchange Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. (Shadab, 2007, paraphrased)

There is also no prohibition from "leveraged trading, short-selling, or concentrated investing." (Shadab, 2007) Shadab states that qualification for the exemptions requires that hedge funds do not advertise and that they only accept investments from wealthy investors and large institutions. There are however, government regulation and oversight to which the hedge funds are subject and included are federal securities law which "...prohibits hedge funds from fraud and insider trading." (Shadab, 2007)

Hedge funds are under a requirement of making disclosures of a substantial nature to potential investors "in order to discharge fiduciary duties and avoid running afoul of antifraud rules prohibiting misleading statements' and omissions." (Shadab, 2007)

Hedge funds must report any "nontrivial holds in public companies" to the SEC as well as reporting "all of their stock holdings on a quarterly basis if the fund has more than $100 million invested in public companies." (Shadab, 2007)

It is stated to be common for a fund to trade futures or commodity options contracts which results in the funds being under the CFTC's scrutiny and as well for a fund to have 25% or even more of its equity assets that are owned by a qualified employee benefit plan which results in the fund ensuring compliance with the Employee Retirement Income Security Act (ERISA). Additionally, Shadab reports that indirect regulation applies to hedge funds and that "federal treasury regulations limit the ability of banks to lend hedge funds, and Regulation '1' of the Federal Reserve Board likewise limits securities brokers-dealers..." And banks are also required to comply "with minimum risk-based capital requirements under the Basel capital accord and are subject to inspection by bank supervisors for exposures to risk." (Shadab, 2007)

Recent Reports

The work of Huang (2009) entitled: "Outlook for Global Hedge Funds Positive" states that according to observers "the outlook for global hedge funds appears rosy with U.S. pension funds likely to drive growth." The challenge identified by Huang (2009) is "how regulations for the industry evolve and are implemented." It is reported that a belief exists that the implementation of tougher policies "will be tricky as this could lead to funds relocating to countries with friendlier regulations." (Huang, 2009)

The report states further that there is a demand on the part of investors for "more operational transparency and better risk management in the aftermath of the financial crisis. Tighter regulations are expected in the hedge funds industry, and some observers said defining and implementing such policies will not be straightforward." (Huang, 2009)

Madoff Scandal and Investor Protection Fears

It was reported by Bloomberg in the December 11, 2008, article entitled: "Madoff Charged in $50 Billion Fraud at Advisory Firm" that Bernard Madoff, found and president of a New York firm "that invested funds for wealthy individuals, hedge funds and other institutions, was charged with operating what he told employees was a long-running $50 billion Ponzi scheme in what may be one of the largest frauds in history." (Glovin and Scheer, 2008)

The report states that Madoff was arrested by the FBI and appeared before a U.S. Magistrate Judge in Manhattan federal court. Charges against Madoff included a single count of securities fraud. It is reported that Madoff was released on a $10 million bond which his wife guaranteed. The SEC filed a complaint in the Manhattan federal court accusing Madoff of "a multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm." (Glovin and Scheer, 2008)

The SEC is stated to be seeking emergency relief for investors which includes a freeze on assets and the appointment of a receiver for the firm. All of this is stated to have come to surface when two of his staff members requested a meeting with Madoff and he admitted that "he was 'finished', that his advisory business is 'all just one big lie' and 'basically, a giant Ponzi scheme." (Glovin and Scheer, 2008) the government reported that the business "had been insolvent for years with losses of about $50 billion..." (Glovin and Scheer, 2008)

Greenwich Associates reports in the work entitled: "Hedge Funds Under the Microscope: Examining Institutional Commitment in Challenging Times"

reports that institutional investment has been a major factor in the phenomenal growth of hedge funds over the past two decades. However, despite investor expectations of enhanced diversification and absolute returns with a low correlation to broad markets, hedge funds, with a few exceptions were not immune to the damage wreaked by the ongoing global financial crisis. Most hedge fund strategies produced double-digit losses in 2008, making it the worse year on record for hedge fund performance." (Greenwich Associates, 2008)

In 2008, it is reported that the majority of hedge fund strategies produced "double-digit losses...making it the worst year on record for hedge fund performance. Hedge funds also saw approximately $70 billion in redemptions between June and November as many institutional hedge fund investors headed for the sidelines or rebalanced their portfolios." (2008)

Greenwich Associates reports that it is against this tumultuous backdrop, [that] the SEI Knowledge Partnership collaborated with Greenwich Associates to conduct a global survey of institutional investors on their views concerning hedge fund investing. Initially, 95 investors in Continental Europe, the United Kingdom (U.K.), and the United States (U.S.) were interviewed in August of 2008. As the crisis deepened, SEI re-interviewed 32 participants from the original sample in November to help gauge the impact of market turmoil on institutional attitudes, policies and plans concerning hedge funds." (2008)

Key findings of the survey are reported as follows:

(1) Institutions have been strengthening their commitment to hedge fund investing. In fact, 62% of first-round respondents said they had increased their allocations to hedge funds in the last two years, with 29% maintaining the same levels. They reported current hedge fund allocations averaging 7.4% of total portfolio assets, slightly lower than the average target allocation of 8.4%. Moreover, 44% said they planned to increase target allocations significantly over the next three years, and nearly half expected to maintain allocations.

(3) Thus far, most institutions are not backing off from their long-term commitment to hedge funds. However, the potential impact of the Madoff allegations, which were revealed in December, has yet to be fully determined. Three out of four investors re-surveyed in the November round of interviews said they had taken "no action" in response to the crisis. When asked why, 83% of those taking no action indicated their commitment to hedge funds has remained unchanged. The remaining respondents had investments that were subject to lock-up provisions and could not be withdrawn in any case. Although the percentage planning to increase target allocations dropped significantly between the first and second surveys, only one institution reported lowering its target hedge fund allocation since the first-round survey. More importantly, 85% of the second-round interviewees said they plan to maintain or increase their target allocations.

(3) a desire for diversification is the most important reason investors are staying the course, although transparency remains a concern. In the first-round survey, a majority of investors cited diversification as their main objective in allocating to hedge funds. Among the second-round interviewees who were planning to increase their target allocations by 10% or more, half named diversification as the motivating factor. Among the approximately one in ten who were planning to decrease allocations by at least 10%, concern with a lack of transparency was the most frequently cited reason.

(4) Institutions are thinking and acting as long-term investors. While almost a quarter of second-round interviewees said they have liquidated some investments or plan to do so, overall the investors surveyed showed no inclination toward a long-term exodus from hedge funds. This is understandable, considering that 93% of all interviewees said they make hedge fund investments with a time horizon of at least three years, and more than half have a time horizon of five years or more.

(5) Investors are, however, realigning the strategies they pursue. Overall, investors said they most prefer multi-strategy, event-driven, global macro, and market-neutral funds for investment in the next 12 months. Convertible arbitrage funds and emerging markets funds of all major regions were most often identified as strategies they intend to avoid. Second round interviewees also reported planning a moderate shift in allocations toward investing in both funds of hedge funds and single-manager hedge funds, rather than single-manager hedge funds alone.

(6) Institutions express growing concerns with their hedge fund investments, topped by "poor performance." Between the first and second surveys, the number of investors naming performance as their biggest worry about hedge funds rose from 67% to 84%. In the 2007 SEI-sponsored survey of U.S. institutional investors, "poor performance" was only the third ranked concern and was named by fewer than one in six of those interviewed. Other top-ranked concerns identified in the current survey were a lack of liquidity, funds not accomplishing their stated goal, and headline risk.

(7) in response, institutions are significantly tightening their investment criteria and intensifying their scrutiny of funds. "Capability of investment professionals" was named a very important factor in the selection of hedge fund managers by 82% of first-round respondents, followed by "firm's management team," "clarity and consistency of investment philosophy," and "clarity of investment decision-making process." When asked which criteria they will give more emphasis to in light of market conditions, second-round interviewees identified several criteria, led by "portfolio transparency." Concerning the minimum standards for consideration of hedge funds, investors said they most commonly apply minimum standards concerning a fund's track record and assets under management.

(8) While increasingly concerned with "institutional quality," investors define it in varying ways. Overall, "pedigree and reputation" was the top-ranked "quality" factor, named by more than half of all respondents, followed by length of track record and assets under management. U.K. investors stand out as gauging institutional quality based on a wide range of factors, while U.S. investors indicated more focus on assets under management and length of track record.

(9) a focus on operational quality also is revealed in the pattern of survey responses. Operational factors including portfolio transparency, communication, and reporting were all ranked among the top selection criteria given added weight in light of current market conditions. Respondents expressed ambivalence when it came to internal fund administration vs. independent, external administration. However, in light of recent scandals, it seems likely that investors will increasingly demand a separation of duties, accelerating the trend toward independent administration and custody.

(10) Expect more stringent due diligence. Always concerned with the factors that drive the pattern of portfolio returns, investors are intensifying their scrutiny of hedge fund investment processes and company structures. Additionally, the Lehman insolvency and the fundamental nature of the Madoff allegations have highlighted issues related to hedge fund operations, counterparty risk, and risk management generally. (Greenwich Associates, 2008)

It is reported that the responses to the surveys provide confirmation of these observations through identification of portfolio transparency and headline risk as top concerns. The survey responses confirm these observations, identifying portfolio transparency and headline risk as top concerns. As the survey results indicate, the events of 2008 assure that investors will be conducting wider-ranging and more in-depth evaluation of hedge funds than before. Investors will have an intensified focus on operations, risk management, and key non-investment functions in addition to investment processes.

Survey results further are stated to have revealed clearly the focus of investors on the fundamentals -- people, process, philosophy, and performance as their top concerns. While other processes and functions are still important the drivers of future success are the fundamentals. Furthermore, it is likely that investors will prefer on an increasing basis a "separation of investment and noninvestment functions as it contributes to operation quality and risk management." (Greenwich Associates, 2008)

There should be anticipation of an increase in client communication, reporting and transparency requirements and it is reported that the second round of responses to the survey revealed that portfolio transparency was ranked "as the top criterion given increased emphasis in light of recent market conditions." (Greenwich Associates, 2008)

The survey responses are stated to indicate that hedge funds are viewed by institutional investors on a continuing basis as "important vehicles for portfolio diversification and absolute return potential." (Greenwich Associates, 2008)

The report of Greenwich Associates includes the prediction that "in the years to come will be those that stand up to intensified due diligence by exhibiting institutional quality, providing more transparency, and delivering consistent, non-correlated returns over time." (Greenwich Associates, 2008)

In a testimony before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises before the House of Representatives on May 7, 2009, Orice M. Williams, Director of the Financial Markets and Community Investment states that the GAO found that under the "...existing regulatory structure, the Securities and Exchange Commission and Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers, and along with federal bank regulators, they monitor hedge fund-related activities conducted at their regulated entities. " (Dawn and Young, 2009)

Although some examinations found that banks generally have strengthened practices for managing risk exposures to hedge funds, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing." (Dawn and Young, 2009) While private sector investment in hedge funds is not specifically limited nor is it monitored by the federal government the fiduciaries must, under federal law, meet compliance "with a standard of prudence" however there are no specific or explicit restrictions on hedge funds which exist.

Hedge funds are inherent with challenges and risks that are "beyond those posed by traditional investment" and the example stated it that some investors are in possession of very little in the way of information on the underlying assets of funds and of their value which is said to limit the potential for oversight." (Dawn and Young, 2009)

Disclosure and transparency has improved among hedge fund advisers as related to their operations due to the guidance provided by the industry as well as investors and creditors along with counterparties applying pressure.

Regulators report that creditors and counterparties "...have generally conducted more due diligence and tightened their credit standards for hedge funds. However, several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk and can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets." Dawn and Young, 2009)

It is additionally reported that concern remains among financial regulators and industry observers in regards to the credit risk management of counterparties at primary financial institutions since it is a critical factor in "controlling the potential for hedge funds to become a source of systemic risk. Although hedge funds generally add liquidity to many markets, including distressed asset markets, in some circumstances hedge funds' activities can strain liquidity and contribute to financial distress. In response to their concerns regarding the adequacy of counterparty credit risk, a group of regulators had collaborated to examine particular hedge fund-related activities across entities they regulate, and the President's Working Group on Financial Markets (PWG). The PWG also established two private sector committees that recently released guidelines to address systemic risk and investor protection." (Dawn and Young, 2009)

The work of Silverblatt (2009) entitled "Kanjorski Discussers Hedge Fund Regulation" states that hedge funds have emerged as a "key puzzle piece. And nearly a year after disgraced financier Bernard Madoff's Ponzi scheme ran out of gas, legislators are considering draft proposals that would tighten the leash around the secretive industry." (Silverblatt, 2009) it is reported that that the drafts were released by Democratic Paul Kanjorski of Pennsylvania, would require private pools of capital with more than $30 million in assets to register with the Securities and Exchange Commission, with an exception for venture capital funds. Practically, this would mean that affected funds would have to disclose information about their fees, risks, trading practices, and other elements of their business." (Silverblatt, 20090 Fund lobbyists have indicated support for registration in what is an "apparent attempt to 'hedge' their bets and avoid further intervention…" (Silverblatt, 2009)

It is reported that the SEC would be allowed to also ban mandatory-arbitration clauses in brokerage contracts. It is reported that separate are legislators in their consideration of a bill that is similar in nature and which is termed as the 'Arbitration Fairness Act'. This act proposed that Congress "…make the clauses unenforceable. By leaving the decision up to the SEC, Kanjorski is hoping to strike a middle ground.

It is reported by U.S. News that when it spoke with Kanjorski about his hedge fund and arbitration proposals, which he released earlier this month and specifically asked the question of Kanjorski of 'Why does hedge fund reform need to be part of the country's broader financial overhaul?" (Silverblatt, 2009)

Kanjorski answered by stating as follows: "One of the important things that we realized and saw vividly this time is the fact that there were so many pieces of information that weren't known as to who was involved in the market and where they were involved and in what amounts. So it became very clear that what we had to do was to make sure that we had the capacity to tap into all the information as to where the money was, who was in charge of it, what they were doing with it, and what type of long-term risk with leveraging could occur. And so there was little question they were going to be regulated." (Silverblatt, 2009) Next Kanjorski was asked if "…requiring registration enough to achieve that, or should Congress ideally go further?" (Silverblatt, 2009)

Kanjorski answered by stating: "I think we should be jealous of how much regulation we put on a business -- or anyone for that matter -- in our system. If we find that this is not sufficient, the SEC will have the capacity to go beyond what we are doing, and of course Congress can come back and give them additional authority if they need it." (Silverblatt, 2009)

Kanjorski was also asked concerning "On the flip side, is there a chance that even the hint of regulation will drive private capital overseas?" (Silverblatt, 2009)

Kanjorski stated: "Anything's possible. But I was just over in Europe, and they're going to coordinate their regulatory reform very closely with ours, so I wouldn't be surprised if we're on the same tack, and we may end up being very close if not identical to each other. . . . If anything, the pressure is that they want high-standard, adequate regulation, too, and they may be pressing us even a bit more." (Silverblatt, 2009)

Kanjorski addressed the question of since "past attempts to regulate hedge funds haven't borne much fruit" if the effort was more viable in nature this time and Kanjoski states "Yes. This time we not only have the members of Congress who are aware of some of the problems that we face and the inadequacies and the holes, but we have the industry on board now to a large extent, recognizing that this is a necessary thing and even helping us by making recommendations as to what can get this through and get it solved in a simple way." (Silverblatt, 2009)

Kanjorski is questioned as to whether he attributed this support to a desire for transparency or if it was an attempt to prevent even stricter regulation." (Silverblatt, 2009) Kanjorski stated as follows: "I think it's a good part of the latter, but anyone who has any insight at all should realize that we came very close to going over the edge, and that if we had gone over the edge, there wouldn't be any such thing as hedge funds or venture capital groups. They would have all disappeared. And so I don't think they want to go through that risk again. On the other hand, like anyone, particularly Americans, they want the least amount of regulatory regime as possible. But I think they think we're being rather reasonable in what we're setting up here, in my legislation at least." (Silverblatt, 2009)