Is "Regulation of Hedge Funds" a Contradictory Term?

Yesterday, on my blog, we discussed a recent article by a legal scholar that argues in favour of allowing US retail investors to buy hedge funds.  Less SEC oversight would likely shift more of the onus on the industry to police itself.  The recent release of recommendations from the President’s Working Group on Financial Reform in the US (see related posting) and the Hedge Funds Working Group in the UK both represent a step in this direction.  But will the be enough to placate government concerns.  Today, we cover an award-winning article that says “no”.   

"Hedge Fund Self-Regulation in the US and UK" by Harvard Law School student John Horsfield-Bradbury was the recent winner of the 2008 Victor Brudney Prize in Corporate Governance for “the best student paper on a topic related to corporate governance”.  Horsfield-Bradbury questions the ability of the industry to police itself, arguing that “self-regulation will not necessarily result in any efficiency gains as government regulators will remain the ultimate drivers of any regulation.”

Horsfield-Bradbury sees hedge funds as a regulatory, not an investment phenomenon…

The phrase “regulation of hedge funds” is a contradiction in terms. Hedge funds are designed to avoid regulation, allowing flexibility in investment for both the hedge fund managers and investors in the fund.

While the article is nothing like the anti-hedge fund material authored by, say, the International Trade Union Congress (see related posting), it certainly can’t be described as pro-hedge fund either.  In fact, it stands in contrast to yesterday’s paper on retail hedge fund investing on many issues. 

Sophistication 

Contrary to the author of yesterday’s paper, Houman Shadab, Horsfield-Bradbury suggests that “financial sophistication” and wealth level are actually quite synonymous.  Not surprisingly, he expresses concern over the fact that inflation now means that a massive 8.5% of US households (many of them unsophisticated) meet the minimum wealth limits required to invest in hedge funds.  In addition, he says that pension fund manager may indeed be “sophisticated”, but their underlying pensioners are not.    

Fraud

Horsfield-Bradbury points out that these unsophisticated investors need to be protected from hedge fund fraud.

The secretive nature of hedge funds means they do not have to disclose information regarding their holdings. As such, they can diverge from stated investment strategies without investor knowledge, or simply engage in fraud. There have been numerous examples of fund managers falsifying their fund’s performance figures in order to attract investors while misappropriating funds.

Shadab, on the other hand, argues that fraud should be the least of investors’ concerns:

However, existing regulation fails to adequately recognize that one of the greatest risks to ordinary retail investors is from market disturbances having nothing to do with fraud or human malfeasance.

Risk 

Despite the lack of a collapse of the financial system after Amaranth, Horsfield-Bradbury says hedge funds remain a systemic risk.  Amaranth, he says, occurred against a backdrop of ”particularly buoyant” financial markets and “plenty of liquidity”. 

Conclusion

Even though Horsfield-Bradbury’s own opinions seem to simmer just below it’s surface, this paper is more descriptive and less prescriptive than Shadab’s.  In fact, it’s an excellent overview of recent regulation history regarding hedge funds in both the US and UK.

Still, Horsfield-Bradbury remains firmly on the fence regarding hedge funds’ motivations to self-regulate:

In an effort to thwart possible government regulation, investors and managers in the hedge fund sector have formed self-regulatory groups to propose possible regulatory solutions. This has received support from many commentators, partly because they believe self-regulation will be more efficient than government regulation. This Paper has shown, however, that recent proposals simply reflect the areas of regulation that government regulators would otherwise engage in. Consequently, a self-regulatory scheme may not be optimally efficient and may not respond as quickly as it could. Other benefits, however, likely make self-regulation worth pursuing. With the coordination of government regulators, trade groups and investors, a global best-practice scheme could be developed.

Comments

[bernie bicoy:]

As the history of continuing financial scandals prove, ''SRO's'' or Self Regulatory Organizations where market participanats under intense pressure to make money - often by fair means or foul - govern themselves....is a lot like foxes being put in charge of the henhouse.

2008 Jul 25 02:53 PM

[bernie bicoy:]

As the history of continuing financial scandals prove, ''SRO's'' or Self Regulatory Organizations where market participanats under intense pressure to make money - often by fair means or foul - govern themselves....is a lot like foxes being put in charge of the henhouse.

2008 Jul 25 02:53 PM

[johnny g:]

two words - MORAL HAZARD

2008 Jul 26 08:22 PM

[believeItOr...:]

Bernie. Your comment is very right on. The problem though is whether government intervention is the answer. I agree with you on so many levels (i.e. Wall Street being the biggest criminals anywhere), but I believe there needs to be a check and balance structure in place that essentially governs by way of true market principles. In absence of that, we have racketeers who dress in suits and make money on "spreads" which is really theft from the middle class (i.e. johnny g who lives in "the peninsula")… while we create more jobs paid by and guarantee by tax payers that are essentially useless.

Also, johnny g, I am proud that you were able to recognize that MORAL HAZARD has two words! Right on! Now go back to renting your house on the peninsula.

2008 Jul 31 04:00 PM