Demands for tighter regulation of hedge funds reached their peak after the collapse of Long-Term Capital Management in 1998. Since then the ...

Demands for tighter regulation of hedge funds reached their peak after the collapse of Long-Term Capital Management in 1998. Since then the mood has tempered but hedge fund regulation is at an interesting crossroads as new types of investors seek to have access to them, money laundering concerns have emerged, hedge fund fraud is evident and conflict of interest accusations linger. Hedge funds are a tough animal to evaluate - they are no different to any other form of investment but the client base they attract and the strategy they demand is unique. Congress and regulators alike still cast a suspicious eye towards hedge funds - new KYC rules have been introduced post-11 September as opinions that hedge funds could be safer havens for money launderers have hardened. Their lack of transparency has also attracted concern and this has increased as hedge funds have become more available to less wealthy individuals and the likelihood increases that hedge funds will be allowed to advertise on a restricted basis in the US. Key figures in the financial world have suggested recently that hedge funds (and especially hedge fund certificates) carry risk on a systemic level to the global financial markets and have asked that key regulators consider a form of international coordinated supervision of hedge funds. The funds’ ability to short markets and stocks without restriction has previously been resented by certain governments and monetary authorities (e.g. Hong Kong during the Asian downturn in the 90s) – they argue that this can create havoc in the market and can be the catalyst of a general price. In Europe, the EU is closer to applying limits on the exposure of employee pensions to high-risk investments like hedge funds. The SEC previously said (Paul Roye, director, division of investment management) in September last year that it should not, and did not want to, regulate hedge funds. The SEC has always been quick to point to the lack of opacity in hedge funds, the relative inexperience that some of the managers have, and the growing instances of fraud in the industry. Some may say that current hedge fund investors can afford to lose a dollar or two - investors in hedge fund partnerships have to be accredited and qualified (accredited means a minimum net worth of more than $1m or annual income of at least $200,000 for each of the past two years – qualified requires a net worth of $1.5m or $750,000 with an investment adviser). The industry is dominated by private individual investment while the institutional market remains sceptical. This is curious because academics have been studying hedge funds at the University of Reading in the UK since 1994 and have shown that including a spread of hedge funds in a portfolio of bonds and equities alters its risk-return characteristics so that the resulting portfolio can significantly reduce the risk of losses with the pay-off being that the positive returns are more mediocre. This suggests that hedge funds are better suited as investments to cautious institutional investors than to risk-prone rich individuals. The studies have also shown that the risk-return characteristics only come into effect when much more than the standard one to three per cent of an institutional portfolio is invested in hedge funds. A hedge fund manager can run 15 different funds with 100 investors in each without needing an SEC registration. Retail investors can get involved in fund of funds products for less than accredited and qualified investors, and many regulators have pointed out that the fiduciary duty for such alternative investments is significantly heightened – diversification and manager selection are important to reduce risk in this respect. Rumour has it that the SEC has changed its tune since last year and is considering subjecting funds to regular exams. In addition, more in-depth and periodic disclosure may be required to both investor and regulator – this could cover holdings, leverage, operations and performance. All investors in a fund may be considered as clients that would increase the need for SEC registration - the investment criteria on net-worth and salary may also be raised. New regulations may be some time coming though – nothing has been drafted yet and these changes may face significant opposition, on top of which the SEC is under-resourced and facing considerable challenges in the wake of Enron and other calls for major regulatory reform. The hope is that the threat of new regulations or a tightening of existing regulations may encourage the industry to police itself better as well as to help drive the fraudsters and sharp-practice merchants out of the industry. The SEC has recently stressed that fiduciary duty is key and this may be the legal angle that the agency uses to pursue those it considers to have abused investors. Some funds are registering with the SEC on a voluntary basis to help stave off such scrutiny, to get used to being regulated and to allow them to use their registrations as a marketing tool to attract new investors, as well as giving comfort to existing clients. Are the new concerns justified? Fraud has been growing but in a $560bn business among 6,000 funds, the losses have been relatively small. Michael Berger, who is still on the run, and the collapse of the Manhattan Investment Fund was well publicised – close to $400m went astray. Inflated valuations at Lipper & Co were another more recent scandal. Kenneth Lipper is a money manager based in New York who ran two convertible arbitrage funds that he assured his investors had increased in value late last year. Just three months later he said that they had actually lost $315m in 2001. He has since admitted the losses were higher and the funds were closed with losses of 45 per cent at one. Convertible arbitrage is meant to offer one of the less risky strategies if short selling is done efficiently to hedge positions. Lipper’s funds had illiquid positions that could not be sold when they needed to be and the internal pricing that was applied was not verified by an independent third party. Other funds have reacted to the Lipper scandal by sending comfort letters to their investors to reassure them about their pricing policies and the methods they use to manage risk. Michael Fanghella, meanwhile, absconded with more than $100m from the PinnFund last year where he was chief executive. News articles have exposed managers with criminal records or those who have falsified academic records who have been sacked from traditional fund management outfits but then found a home in the hedge fund sector. The suggestion has also been that unsavoury characters are attracted not only to work in the industry but also as investors. The hedge fund industry is set to remain in the spotlight for now and no one yet knows which way regulation of it will go.