Balancing Sensible Governance against Failed Principles: Is this the End to the Wild West of Investing?
Like the Wild West, hedge funds are a largely unregulated investment vehicle marketed as a tool for reaping large returns for investors willing to accept higher risk. In the current climate of market volatility, it appears that a sheriff is riding into town and the Wild West of investing may soon end.
From 1999 to 2004, hedge fund assets under management grew by more than 260 percent. It is estimated that by the summer of 2007, more than $1.9 trillion was under management at more than 9,000 hedge funds.
Recently, at the Hedge 2008 Conference in London, one prominent hedge fund manager stated, "In a fairly Darwinian manner, many hedge funds will simply disappear." According to hedge fund research, investors removed $43 billion from hedge funds during the month of September and losses for the past three months top $210 billion.
The question moving forward is, "Who will the sheriff be and when will the sheriff arrive?" As we see it, there are three possibilities.
Public Pensions and Retirement Funds
Driven to maintain or exceed a higher return rate for their retirement systems, many public pensions have decided to invest in this high-stakes corner of the investment world.
United States public pensions are uniquely poised to change how these investments are regulated including advocating for transparency from hedge funds and pursuing recovery for investors.
By early 2007, United States public pension funds had invested $24 billion in hedge funds.
The dilemma is clean, in a climate nearly devoid of oversight, hedge funds do not report trading positions or holdings. They are not required to report how much they owe or to whom they owe. Such strategies are typically at odds with the transparency requirements for pensions.
The Securities and Exchange Commission
Regulation of hedge funds has been a recurring battle and one the SEC has lost on numerous occasions.
In 2006, the Securities and Exchange Commission passed the Hedge Fund Rule that required hedge funds managing more than $25 million to register with the SEC, provide details about operations and submit to periodic audits.
The SEC's attempt to impose regulation was as short lived as the sheriff riding into early Tombstone. The Hedge Fund Rule became effective on Feb. 1, 2006, and by June of 2006, the Court of Appeals for the D.C. Circuit shot the rule off its horse.
On Sept. 17, 2008, SEC Chairman Cox asked the commission to consider an emergency disclosure rule requiring hedge funds and other large investors to disclose their short positions. Managers with more than $100 million invested in securities would be required to begin publicly reporting their daily short positions.
The SEC's proposed rule was altered when the SEC changed course because hedge fund managers complained that requiring public disclosure would put them out of business because other investors could copy their investing strategies. In response, the new SEC rule only requires hedge fund managers to report their short positions to the SEC on a weekly basis and not to the investing public.
On Oct. 15, 2008, the SEC extended the rule to Aug. 1, 2009.
Additional SEC efforts to regulate are likely to emerge in the short term. Turning to the last option, legislators are faced with the burden of fixing a broken market.
Legislators
So, what reforms may be riding into town?
We know that hedge funds are fiercely protective of their investment strategies and that they are girding themselves for a fight over disclosure and regulation. It is clear that this industry is currently under the microscope and there is strong backing from political leaders throughout the country to regulate hedge funds.
There are three schools of thought emerging in Washington:
Analysts are floating ideas about disclosing investments 45 days after the close of a quarter to allow for a cooling period - making any disclosures historic;
- Full disclosure to the SEC is necessary but can be confidential; or
- Total transparency to the market - meaning full disclosure to all.
- Regardless of the source or solution, reform will take time.
Before reform is agreed upon and in place, the leading edge may come through private litigation. Numerous hedge funds are being sued by investors, including public pensions, for various causes of action including breach of fiduciary duty, gross mismanagement, breach of contract, fraud, negligence, and violations of federal and state securities laws.
As Ann Yerger, executive director of the Council of Institutional Investors recently stated, "Now is not the time to yield to pressure from Wall Street lobbyists to further shelter financial firms."
Indeed, now is the time to guide hedge fund reform and to create sensible reforms in the face of failed principles.
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