With all the finger-pointing going on right now on Wall Street, the topic of hedge fund regulation is never far from the front pages. So today and tomorrow, we will review a couple of comprehensive, but very readable essays written not by financial academics or hedge fund managers, but by legal scholars. These papers paint a contrasting picture of the most appropriate regulatory framework for hedge funds.
The first, which we discuss below, was written by Houman Shadab of George Mason University. Shadab’s article “Fending for themselves: Creating a U.S. hedge fund market for retail investors” was published in the Spring 2008 NYU Journal of Legislation and Public Policy and is available here. In it, he argues that “financially sophisticated” US retail investors are actually hurt by regulations preventing them from investing in hedge funds, not helped by them.
The second paper, covered tomorrow, defends government regulation of hedge funds, stating that “self-regulation will not necessarily result in any efficiency gains as government regulators will remain the ultimate drivers of any regulation.”
Shadab’s paper starts by saying that the US actually has a relatively restrictive hedge fund regulation:
“…Australia, Switzerland, Hong Kong, Singapore, and Ireland have successfully permitted retail investors to invest in hedge funds, and other foreign jurisdictions such as the United Kingdom are in the process of expanding access. Although the Securities and Exchange Commission (SEC) has expressed interest in broadening access to investment strategies of the kind employed by the funds, it has yet to offer any concrete reform proposals.”
He points out that current wealth thresholds allow 8.5% of US households to invest in hedge funds while proposals to raise this threshold would mean on 1.3% of US households could invest in hedge funds. (While this appears to be an 85% drop, an informal scan of research on wealth distribution conducted by AllAboutAlpha suggests this amounts to cutting the potential pool of financial assets by approximately 50%.)
Shadab’s basic argument is that “financial sophistication” and wealth level are not perfectly correlated. So there are a lot of investors who can get their head around hedge funds, but still aren’t allowed to invest due to wealth restrictions.
Fair enough. But what about the danger of attracting unsophisticated non-wealthy investors to hedge funds? Shadab says this danger is minimal…
“Unsophisticated retail investors are highly unlikely to express a demand for hedge funds, much less undertake the effort to invest in the funds. This is because research finds that retail investors are typically risk averse, fail to properly diversify their portfolios, and biased towards investing in companies they are familiar with, even when doing so undermines their economic interests.”
In response to those who argue that lack of transparency should confine hedge funds to the rarified quarters of the super-rich, Shadab says that popular perceptions are incorrect…
“Hedge funds are widely regarded as highly opaque investment vehicles. This is a misunderstanding…as a matter of law and practice the funds make substantial and detailed disclosures…
“Hedge funds often make substantially greater and more intelligible disclosures than those found in a registration statement or made by registered investment companies under the Company Act. These disclosures include detailed monthly or quarterly summaries of relevant market conditions and trading strategies, relative performance data compared to benchmarks such as hedge fund indices, equity indices, and Treasury yields, and descriptions of what losses were attributable to what strategies or investment group.” (our emphasis)
Anyone out there who has ever been involved with a due diligence meeting with potential hedge fund investors is probably nodding their head right now and yelling “amen, brother!”. But what about the potential for retail investors to enjoy this level of transparency? As retail adoption occurs, says Shadab, transparency will evolve out of competitive necessity (ed: apparently not yet – see news story this week).
Okay, but even if these transparency issue were addressed, hedge funds are still too complex for retail investors to understand, right? Wrong, says Shadab. Hedge funds are no more complex that multi-billion dollar corporations with thousands of employees, hundreds of offices and untold numbers of potential blow ups around every corner…
“…in today’s investment marketplace, retail investors cannot avoid highly complex investment risk. Even simple investment strategies are complicated because of the complexity of issuers’ business operations in a global and information-based economy. For example, retail investors in registered information technology, financial services, and health care provider companies…likely have little understanding of the complex technological, financial, and scientific expertise underlying their securities’ values or the risks to which such companies are exposed through inflation, foreign exchange fluctuations, patent acquisitions, and regulatory developments.”
Although it sometimes seems that Shadab is arguing for little or no “protection” for retail investors, his prescription contains three proposals that make the process of retail investment in hedge funds substantially different than that of institutional (and high net worth) investment.
His recommendation is to allow funds of funds to list on US exchanges, actively encourage a liquid secondary market (see related posting), and allow hedge funds to advertise and market themselves to retail investors (see related posting).
Shadab does not specifically address the issue of self-regulation, although he certainly advocates for a less active SEC. Like the omnipotent Chuck Norris, sophisticated retail investors may actually be able to fend for themselves.
Tomorrow, we will discuss another recent paper that questions whether the government can really get out of the hedge fund regulation game anyway.