TCS Daily

Don't Trim the Hedges

By Dominic Basulto - August 11, 2005 12:00 AM

The worldwide hedge fund industry has nearly tripled in size over the past five years to become a $1 trillion behemoth capable of moving financial markets in a matter of minutes. But does that mean that they should be tied up in more regulation?

To their critics, it does. The very size of hedge funds raises fears for them of market manipulation in the pursuit of short-term gains and the potential for widespread fraud.

European and Asian financial regulators already are on the march. In the UK, the Financial Services Authority (FSA) has hardened its stance against the hedge fund industry, releasing a discussion paper linking hedge funds to market manipulation. Recently, the chairman of the Social Democratic Party in Germany even described hedge funds as "swarms of locusts that fall on companies, stripping them bare before moving on. ..."

Meanwhile, here, the average person on the street sees hedge fund as super-secret tools for the very wealthy run by shadowy characters on remote Caribbean islands pursuing esoteric trading strategies that profit from financial mayhem in the world. Any market hiccup -- like the recent downgrade of General Motors debt to "junk" status by U.S. rating agencies -- is viewed with horror as a potential opportunity for hedge fund speculators to bring down the world financial markets, with fund critics raising the specter of Long Term Capital Management in 1998 as proof that hedge funds -- if left unchecked and unregulated -- could cause a worldwide financial meltdown.

The truth about today's hedge funds, though, is much different.

Granted, the ability of hedge funds to move quickly in and out of positions sometimes leads to a herd mentality as groups of investors attempt to exploit the same investment ideas, and they can apply pressure on company management. But hedge fund managers are not James Bond villains with MBAs. They play an important role by taking a hard look at internal management problems and in pricing financial assets -- actions that provide important information to the broader market..

Furthermore, as Federal Board Chairman Alan Greenspan has noted more than once, hedge funds provide an important source of market liquidity -- especially during times of financial stress. They smooth out market fluctuations by taking positions nobody else wants and help to allocate capital efficiently to other market participants. According to Wharton finance professor Jeremy Siegel, hedge funds provide a market for securities that investors might otherwise find difficult -- or impossible -- to trade.

In the seven years since the Long-Term Capital Management debacle, hedge funds have much improved their ability to manage risk, monitor counterparty exposure levels, and keep close tabs on the management teams at other hedge funds. As a result, the incidence of fraud in the hedge fund industry is actually much lower than in other segments of the financial services industry. For example, of the 2,600 enforcement actions brought against the hedge fund industry over the past five years, only 46 have involved hedge fund advisors.

No wonder that at the Reuters Hedge Fund Summit in June, institutional investors concluded that, as a whole, hedge funds are a "force for good" in the financial markets. And no wonder, too, that Greenspan and U.S. Treasury Secretary John Snow have spoken out against additional regulation of the hedge fund industry by the Securities and Exchange Commission here.

Newly-appointed SEC chairman Christopher Cox should listen to them and resist the critics' calls to tighten up regulation. Forcing hedge funds to disclose more information about their executives, trading strategies and valuation methods may lead to greater market transparency -- but not necessarily to greater accountability. In fact, the SEC still has failed to demonstrate that any proposed regulation of the hedge fund industry would be an effective deterrent to fraudulent activity. In all likelihood, the cost of any additional regulation would far outweigh the benefits.

It may be problematic to overturn William Donaldson's handiwork -- a rule requiring all hedge fund advisors with more than 15 U.S. investors and more than $30 million in assets to register with the SEC by February 2006. The industry and investors may just have to learn to live with that expensive and inefficient registration scheme. But the SEC should say no to any regulation beyond that. For anything more would almost certainly have a negative impact on U.S. financial markets by reducing the ability of hedge funds to absorb external shocks and allocate capital to the highest returns. America has huge financial markets; it needs a big hedge fund industry to help keep it afloat.

Dominic Basulto writes about technology, business and venture capital markets for TCS.


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