24 May 2007

Hedge Funds: Crystal Ball on Regulation...

Looking into the crystal ball for the future regulation of hedge funds is a cloudy subject and the feds are making statements that would alarm any high net worth investor. So what are the issues with asking for some additional transparency and reporting mechanisms for the 1% who choose to diversify their portfolios?

Why is regulation inevitable? There are a number of factors, including:

  • Industry growth and the increasing influence of hedge funds in the capital markets.
  • The absence of genuine regulatory oversight.
  • The changed political landscape.
  • Increased participation by public pension funds and corporate pension plans.
  • Continuing instances of fraud and blow-ups.
  • The lack of transparency.
  • Increasing complexity and concerns of systemic risk.

All of these factors, taken together, have created an environment that is ripe for regulatory oversight. Of course, this does not mean that hedge funds should be regulated. Indeed, there are good arguments that hedge fund regulation is not necessary, and may even be imprudent. Opponents of regulation have argued persuasively that, among other things, hedge funds provide benefits, such as market liquidity, and that regulation will simply drive hedge funds offshore.

As the financial wizards of the global markets figure out ways to keep regulators from asking too many questions the leadership of the companies operating in the hedge fund environment are getting prepared. They are strategically implementing the mechanisms and the controls that any prudent investment management company have in place to deal with the operational risks associated with other main stream institutions in the sector.

So what is on the mind of the SEC and others who oversee the implications of hedge funds that are not being so proactive:

The hedge fund industry, long a Wall Street innovator, has frequently created exotic money-making strategies that have then ballooned in popularity.

But as Neil Brown, director of AIMA and managing director of New York-based Citigroup Alternative Investments, noted, when a profitable arbitrage trade is uncovered, managers then pile onto the trade, and the opportunity to make money gets "arbed away."

This summer's meltdown in convertible bond hedge funds proved a wrenching case in point. Convertible arbitrage managers buy convertible bonds, which are bonds that can be exchanged for a certain amount of a company's common stock, and short the underlying stock of the issuing company to profit from the difference in price between the two securities.

Long considered a safe haven, the strategy posted big losses this year, which forced three big convertible bond hedge funds to close: San Francisco-based Marin Capital Partners, which had $2.2 billion in assets at its peak; Alta Partners, run by San Francisco-based Creedon Keller & Partners, which had about $1.2 billion at its peak; and Minnesota-based EBF & Associates' $669 million Lakeshore International Fund.

Now, hedge funds are coming up with new, more exotic strategies as traditional strategies, such as certain kinds of arbitrage, get overcrowded.

So what? The fact that the markets will regulate itself is a valid point being made around many dinner tables in London, New York City and Shanghai as hedge funds managers can feel the trend of fraud driven regulators breathing down their necks:

Shanghai is setting up a financial task force to counter a rise in cases of fraud and other abuses linked to soaring stock prices, state media reported Tuesday.

The task force, including staff from the securities and banking watchdogs, police and other government agencies, will focus both on combatting illegal share dealings in companies not listed on the bourse and also on the practice of diverting public funds into high-risk investments, the state-run newspaper Shanghai Daily reported.

"Risks are accumulating and we should be well aware of illegal financial activities and make it a priority of our work to clamp down on them," it quoted Feng Guoqin, a Shanghai vice mayor in charge of the task force, as saying.

So why are hedge funds any different than any other alternative investment? The myths are there and they need to be addressed:

Hedge funds often are said to be unregulated or lightly regulated. The perception is that hedge funds are cowboys taking advantage of the wild-west financial markets without a sheriff in town.

Hedge funds are required to comply with every rule, regulation, and law that affects virtually all investors in the public and private financial markets. Further, hedge funds are subjected to a variety of investor-related laws and regulations that impact who can qualify to invest with hedge funds. Additionally, there are a variety of state and federal laws that can require some managers to register as investment advisors—thereby invoking a series of additional regulations and requirements, including periodic regulatory examinations and filings. When the topic of regulation arises in the hedge fund industry, managers are far from being cavalier about the existing and continually proposed regulatory requirements.

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