View From a Height

Laboratories of Finance

The Wall Street Journal reported this morning on the proposed impending regulation of hedge funds ("Hedge Funds Brace for Regulation"):

Last year, amid the growing surge of interest from investors in hedge funds, William Donaldson, the outgoing chairman of the Securities and Exchange Commission, championed a staff recommendation that most hedge-fund managers register with the SEC as investment advisers. More pension plans, endowments and charities have shifted into hedge funds, which more directly impacts smaller investors. Sparking additional concern, more investors today meet the wealth requirements to invest in hedge funds -- set to be raised to $1.5 million of net worth, from $1 million. An estimated 8,000 hedge funds worldwide manage about $1 trillion in assets.

Even more important, the growth of hedge funds and the fact that they often use borrowed money to expand their investments means that the funds play a bigger part in daily movements of the market. Mr. Donaldson last year said the agency "needs to have a means for examining hedge-fund advisors and monitoring their activity."

The rule change, which doesn't have the support of certain officials, including Federal Reserve Chairman Alan Greenspan, is scheduled to take effect in February 2006 and would subject hedge-fund firms to regular audits and inspections. Funds also will have to provide the backgrounds of their executives, details of their trading strategies and how they value their portfolios, among other things. About 35% or so of hedge-fund managers currently are registered with the SEC.

Hedge funds were exempted from the 1940 regulation because of two assumptions: 1) people with net worth of $1 million didn't need to be protected - a somewhat patronizing assumption perhaps, for the rest of us, and 2) no individual fund could move the market.

Now, just because pension funds are foolish enough to invest in these things doesn't mean that they should be regulated. After all, Schwab doesn't consider roulette to be suitable investment for my IRA money, but Vegas still stays lit at night. Thanks to my water, of course. Ahem. But I digress.

The better reason for some hedge fund regulation is that the assumptions aren't operative any more. While $1 million isn't chicken feed, many many middle-class families can aspire to that goal within their lifetimes. And if Meriwether and his Meri Band of Academics at LTCM taught us anything about letting them outside the classroom, it was that one well-placed, poorly-timed, over-leveraged, under-supervised group of kids can spoil it for everyone.

Here's the problem, though:

Hundreds, if not thousands, of firms manage less than $100 million, and they might not be able to bear these burdens, some say. A $50 million firm, for example, likely charges its investors about 1% of assets a year as a management fee to cover the running of the fund. With the cost of registering so high, at least in the first year, some might think twice about starting their own funds.

A good compliance officer can pretty much eat up the entire fee of a small fund. While the Wild West mentality of most hedge fund managers will lead them to rebel at first, the larger funds will soon find, like their bretheren in other industries, that regulation is a swell barrier to entry.

Why do we need smaller funds? As the laboratories of finance. They're more nimble, can liquidate positions more easily without moving the market, and often represent the newer, more innovative uses of modern finance theory. If someone has a creative way of combining derivatives, they ought to be free to pursue that without having to tell the whole world what they're doing.

So instead of simply regulating the entire industry, which can only stifle innovation, the SEC should consider either one threshold, or a series of them as the fund increases in value, leverage, and impersonality.