Thursday, January 12, 2006

Hedging the Hedge Fund

Starting in February of this year, hedge funds will now be subject to a smattering of regulations under the Investment Advisers Act. Previously, hedge fund investors were subject only to the terms of the investment agreement, which varies from fund to fund. Now the SEC imposes restrictions that require each fund to have a Chief Compliance Office and each fund adviser to be registered with the Commission. Policies are in place to ensure that client securities are in the best interest of the client. There’s also a code of ethics involved.

What made hedge funds attractive from the outset were the degree of freedom they had from regulation, and the steps they could take because of that freedom that traditional mutual funds could not. The “hedge” in hedge fund comes from the ability of the fund manager to borrow against the value of the securities in the fund and, subsequently, to take higher risk positions. Mutual funds managers are severely restricted in their ability to use leverage as an investment strategy, and as a result, limited in their ability to move the fund forward using their better judgment. In addition, mutual funds are required to be priced at day’s end; the value of a hedge fund could be indeterminate at any time. Fees are a big issue with the NASD—not only is the amount changed under restriction, but the format under which the fees are presented in the prospectus and by the salesman to the buyer must follow certain guidelines. Hedge funds do not put up with such nonsense.

I wouldn’t expect the regulation of hedge funds to cease at its current level. After a few more rounds with Uncle Sam, a hedge fund will be nothing more than a glorified mutual fund. These rules are undoubtedly aimed at protecting the consumer (that, and keeping the SEC well employed)—but what it does is rob the investment industry of the market process. It’s remarkable how much the SEC and NASD imply that people can not figure their investments for themselves. Every time you read “protect the investor,” translate to “we feel you don’t know what you’re doing, so we’re going to tell you instead.”

But better laugh than cry; the irony, of course, is that this wave of rules is designed to protect the unknowing hedge fund investor—investors which, due to investment minimums with hedge funds and that wily market process, are weeded out in the first place.


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