Regulation of Hedge Funds

Michael W. Tabayoyon on The Public Regulation of Mutual Funds, and Hedge Funds


The public regulation of hedge funds is of utmost importance since many regulators and congressional committees have targeted them in this current “credit crisis”. Investigations into Bernard Maddoff's Hedge fund also raise many questions about Private Regulation D Investment holding companies. In this paper we look at the history of regulation, the mutual and hedge fund, arguments for tighter regulation of hedge funds, and how hedge funds have become exempt from regulation.



A History of regulation and the current crisis.

According to Sergey Francois the securities Act of 1933 was aimed at securities issuers and Compliance with SEC filing and registration requirements for securities, compulsory transparency, management, holdings, fees, expenses. Securities Exchange act of 1934 was aimed towards brokers and changed the maintenance of detailed records of trades to avoid conflicts of interest in executing customer orders as well as trading on its own account; costly reporting requirements. The investment advisors act of 1940 was aimed at mutual funds and it changed the Registration as an investment company. It engaged restrictions on leverage fees, and Investment diversification rules. Mandatory disclosure, required distributions to equity owners each year. It required a majority of disinterested directors on board of directors. The blue skies laws were established at the state level to maintain integrity of markets. In 1996 the Clinton Administration engaged the national securities markets improvement act.[1] This was passed and it amended the previous acts. In the first 3 months of 2008 the Treasury department has been talking about improving the financial markets once again. The financial industry is vast with a wide array of consumers and participants. The financial markets main use is a system of intermediation that helps savers and borrowers accomplish their goals. [2]



Hedge Funds and Mutual Funds

Publicly held companies, such as mutual funds, are comprised of smaller stakeholders. These funds, with many more investors, are required to keep their passive shareholders updated on their investment performance. These are managed investment companies with stakeholders that are not involved with the investment decisions, but only capitalize the fund. Since there are so many passive investors, the managers of the mutual funds have become responsible to make profitable decisions that will benefit the company and their investors. The variety of mutual investment companies are a product of a healthy market. Hedge funds are a smaller set of investment companies that have traditionally been established on and offshore of a domestic economy. These funds target high net worth investors and not thousands of small net investors. They have not been required to maintain transparency of their financial statements to the public. An increasing number of institutional and private investors have started investing in hedge funds and are seeking higher risk adjusted returns, and greater portfolio diversification and more protection from risks associated with the end of an aging bull market. Some common myths say that hedge funds not only offer huge returns, but they also appear to have the ability to undermine central banks and national currencies and even destabilize international capital markets. Many hedge funds aren’t hindered as much in sec registration, by the investment company act, and investment advisors act.



Arguments for regulation

Schroder’s investment management CIO says hedge funds need more regulation. In An interview with Financial Times, Mr Alan Brown said “Hedge funds should expect their behavior to be scrutinized more closely, and could be brought into the regulatory net most asset managers are already in, he said. "And rightly so, as they become more open to smaller investors.”[3]

Treasury Representative Henry Paulson interview with Kim Landers ABC News said More power for Fed in historic Wall St overhaul. His blueprint for reform would give the Fed the power to examine the books of any financial institution, banks, hedge funds and private equity firms that might pose a threat to the stability of the financial system."It will focus on whether a firm's or industry's practices threatened overall financial stability," Mr. Paulson said. "It will have broad powers and the necessary corrective authorities to deal with deficiencies that pose threats to our financial stability."There will also be a single regulator for the nation's banks and credit unions, and mortgage brokers will have to be licensed for the first time. The US Treasury's blueprint mentions Australia as a possible model.[4]

The financial regulatory structure in the US is badly outdated. Dr Nariman Behravesh is the chief economist with Global Insight, a forecasting firm. And he makes that claim that this financial overhaul has been in need for some time now."You could argue that Wall Street brought this on themselves, but I think change was overdue and there has been a lot of talk about regulatory restructuring in the United States," he said. "I think this crisis has hastened that need and has created an urgency about this reform right now.“[5]



Policy and Regulation Discussion- Pros and Cons

Hedge funds are of particular interest in regulation since they have grown in use recently. The assets in hedge funds grew %27 in the first quarter this year indicating their growing importance in the financial investment market. [6] They believe that the current financial crisis could be eased if hedge funds were “more transparent” and if they disclosed investment information. The tricky thing about hedge funds is that they are capitalized by few very wealthy owner managers, and not many small investors. But more recently this has changed. Now hedge funds are opening their investments up to more share holders and this has complicated things. Some hedge funds have begun to act more like mutual fund companies. Policy makers face problems with the players on financial markets. Some say “the railroad laws are written in blood”. As we saw before in the history of financial regulation, many of these acts were engaged because of certain “market failures”. Economists disagree and say that problems in financial systems are the result of government interaction. So if the government would let the market determine its own path, in the long run, there would be greater stability. Regulators and the creation of transparent financial regulation say that financial crisis leads congress and regulatory committees to enact and enforce policy that will facilitate a stable financial system.

The $ cost of regulating financial markets in United States is something to consider. Howell Jackson says ”The United States, for example, spent nearly $6 billion on financial regulation in 2004 and employed more than 43,000 staff members, which is equivalent to 133 staff members for every million people in the population.[7]

Howell Jackson’s research spoke about the benefits of regulation: “several years ago, I attempted to summarize the goals of financial services regulation in the United States. At the time I contended that regulatory intervention in this field was designed to produce four distinct social benefits, with the relative importance of the benefits varying somewhat across different sectors of the industry: 1. Protection of General Public 2. Elimination of Negative Externalities from Financial Failures 3. Advancing Various Equitable and Redistributive Goals 4. Promoting Certain Aspects of Political Economy”[8]


Howell Jackson identifies the goals and benefits of financial regulation.

“1. Protection of General Public. In certain contexts, this goal is defined as the achievement of the level of protection that fully informed and fully rational investors, depositors, and insurance policy holders would choose for themselves; a hypothetical contract approach to regulation. Other times, this objective is cast in a more paternalistic light, imposing absolute protection on the general public without regard to their preferences.”(Jackson)[9]

2. “Elimination of Negative Externalities from Financial Failures. The most prominent sort of negative externality is the elimination of systemic shocks to the economy that financial crises could precipitate. A variant of this objective is the elimination of the costs that society would bear if members of the general public suffered losses from financial institution failures and then demanded ex post compensation from public resources.”(Jackson)[10]

3. “Advancing Various Equitable and Redistributive Goals. Though present in a smaller share of financial regulations than the preceding two objectives, equitable and redistributive objectives are undoubtedly present in some areas of U.S. financial services regulation. In banking, for example, some regulations steer lending into particular markets to enhance economic development or to promote certain activities; in insurance regulation, some degree of cross-subsidization between insurance pools is mandated to advance social goals independent of (and sometimes at odds with) solvency concerns.”(Jackson) [11]

4.” Promoting Certain Aspects of Political Economy. Finally, some aspects of financial regulation reflect political compromises. Longstanding barriers to the geographic expansion of banks are one good example, but so are restrictions on commercial activities of financial holding companies and certain aspects of SEC capital market regulation.”[12](Jackson)

Even with the benefits of regulation defined it is difficult to measure them. Howell Jackson’s research finds that an estimated $6billion is spent on financial services regulation per year and an estimated 43,000 people are employed in financial regulation in the United States. Many believe that the Securities and Exchange Commission is justified since it promotes integrity and stability in financial markets. This is true in the case of investments where many people participate with little or no contact to direct actions of the Investment Company or sole company. The case of the hedge fund is different of course if the hedge fund remains a hedge fund and does not begin to take on the characteristics of a mutual fund. That is, if the hedge fund is an investment company that has few investors that are directly involved with the actions of the investment company and its capitalization.

$6 billion a year is a large sum of money to spend on the maintenance of financial services regulation. The treasury department head Henry Paulson has his sights on the regulating the activities of private funds held in hedge funds that often are held offshore and onshore around the world. Henry Paulson says “Since so many pension funds like cal per’s invest money into investments like hedge and mutual funds the managers of pension funds have the responsibility to protect the asset of Americans on the verge of retirement. If you leave these funds unregulated you will put the old and elderly in jeopardy. This policy of unregulated pension fund investment funds could lead to catastrophes similar to the likes of Enron. “ [13]

But don’t you think that managers of pension funds have the responsibility to their stake holders to make wise and informed investments that have little risk of loss. They also have the generating a return on investment with the savings. They have the responsibility to invest into safe securities and avoid ones that are too that are too risky for the returns they want to realize.







Conclusion:

The past shows that the federal and local government has been tightening down over time. This can be seen as long ago as the 1930’s. Some authors say that regulators develop plans for tighter rules and pull them together when crisis strikes. By looking at the current arguments for regulation we can see that managers, government officials and other market participants make persuasive claims that the financial markets must be scrutinized for the good of society. We defined the Hedge Fund and the Mutual fund as two distinct examples of investment vehicles that require different regulatory treatment. The dialogue between hedge funds investors and public mutual fund companies followed. It is very important that truth is separated from the fog of financial crisis. It’s important that federal regulatory committees focus on the right market participants. Hedge fund managers don’t have a fiduciary responsibility to thousands of shareholders but rather a small group of wealthy investors. Publicly trade mutual fund companies have a fiduciary responsibility to manage thousands of passive investors. The public companies should maintain transparency of finance info but regulators should be careful not to invade private investor’s information. On one hand the history of financial regulation is used as evidence of a stable 20 years under the green span watch but economic principles show us that incentives matter. If the cost of investing money in financial markets black markets can arise, or people just exit the market in search for more profitable activities. If a healthy financial system is the goal then an overburdened tax and regulatory system will push investors out of the market. This would lead to the supply of loan able funds and investable funds severely lacking. Financial Intermediation and good investment vehicles are goals of investment companies.

[1] Hedge Funds- Myths and Limits

[2] Sergey Francois -Hedge Funds

[3] "Schroders CIO says hedge funds need more regulation"

[4] Kim Landers ABC News

[5] Hedge Funds need more oversight

[6] The financial structure is badly outdated.

[7] %27 growth in hedge funds WSJ

[8] Intensity of financial regulation

[9] Howell Jackson- intensity of financial regulation

[10] Howell Jackson- intensity of financial regulation

[11] Howell Jackson- intensity of financial regulation

[12] Howell Jackson- intensity of financial regulation

[13] Howell Jackson- intensity of financial regulation

[14] Paul M. Healey "the fall of Enron"





Works Cited

Regulation? Plus ca change for investment banks

TONY JACKSON. Financial Times. London (UK): Apr 7, 2008. pg. 20





Hedge Funds Need More Oversight, Transparency, Treasury Panels Say

By David Cho Two committees appointed by the Treasury Department called yesterday for greater accountability within the secretive world of hedge funds and ... Washington Post, United States - Apr 15, 2008 http://www.washingtonpost.com/wp-dyn/content/article/2008/04/15/AR2008041502807.html



KATHY SHWIFF Hedge Fund Assets Grew 27%Hedge funds world-wide had $2.65 trillion in assets under management at the beginning of 2008, up 27% from a year earlier, according to new Wall Street Journal. http://online.wsj.com/article/SB120835749453919575.html?mod=googlenews_wsj





Francois-Serge Lhabitant, Hedge funds Myths and Limits John Wiley & Sons .Baffins Lane, Chinchester, West Sussex PO 19 1UD England



United States Taxation and Regulation of Offshore Mutual Funds. Harvard Law Review, Vol. 83, No. 2 (Dec., 1969), pp. 404-452 Publisher: The Harvard Law Review AssociationStable URL: http://www.jstor.org.libaccess.sjlibrary.org/stable/1339676



Paul M. Healy and Krishna G. Palepu The Fall of Enron .The Journal of Economic Perspectives, Vol. 17, No. 2 (Spring, 2003), pp. 3-26Publisher: American Economic AssociationStable URL: http://www.jstor.org.libaccess.sjlibrary.org/stable/3216854



PAULINE SKYPALA Schroders CIO says hedge funds need more regulation. Financial Times. London (UK): Apr 14, 2008.



Howell E Jackson Variation in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications. Yale Journal on Regulation. New Haven: Summer 2007. Vol. 24, Iss. 2; pg. 253, 39 pgs









[1] Hedge Funds- Myths and Limits

[2] Sergey Francois –Hedge Funds

[3] Schroders CIO says hedge funds need more regulation

[4] Hedge Funds need more oversight

[5] The financial structure is badly outdated.

[6] %27 growth in hedge funds WSJ

[7] Intensity of financial regulation

[8] Howell Jackson- intensity of financial regulation

[9] Howell Jackson- intensity of financial regulation

[10] Howell Jackson- intensity of financial regulation

[11] Howell Jackson- intensity of financial regulation

[12] Howell Jackson- intensity of financial regulation

[13] Paul M. Healey “the fall of Enron”