Somewhere behind the debate on banking regulation in the West is the debate on what to do about hedge funds. There were, after all, many scandals and liquidations across a wide swath of the hedge fund industry during the recent subprime crisis.
The EU, around the time of the G-8 summit, issued a draft directive on Alternative Investment Fund Managers, with a number of provisions that require managers to regularly disclose their risk-management strategies, their positions and returns, audit arrangements and other such information to the regulator. This suggestion has been the cause of a huge uproar amongst the hedge fund community, especially in the UK. Public figures like Boris Johnson, London’s mayor, have come out with strong public statements against the draft directive, top hedge funds have spoken out in the press against any additional imposition of regulation, and the debate continues to rage on. India’s regulators must be watching these scenes with great interest to see where it all shakes out: How should hedge funds be regulated? Indeed, should they be regulated at all?
The issues are contentious no matter which way you look at them. On the one hand, the average, non-fraudulent hedge fund was more the victim than the culprit of the recent financial crisis. It’s also the case that bad news, such as news of frauds, is more likely to be disclosed during market downturns. Moreover, many hedge funds’ business models are based on the premise of providing liquidity to markets and garnering returns by harvesting liquidity premiums. This is an important public service and one that needs to be considered carefully when evaluating the consequences of imposing harsh regulations on them. Another important public service that they provide is that in theory, hedge funds should help to make financial markets more efficient by disciplining prices towards their fundamental values.
On the other hand, there are some important issues, including a number of curious facts about hedge funds. First, a growing body of academic research shows that hedge funds don’t really provide ‘absolute returns’ as they often promise, since their returns are often highly correlated with movements in the market. This means that many hedge funds are likely taking on a good amount of systematic risk. Second, it has been documented that operational risk is an important component of the risk of investing in hedge funds. This form of risk can be mitigated (and predicted) by acquiring simple information such as whether the hedge fund has an independent and well-respected auditor; whether the fund or fund manager has a history of legal or regulatory problems; whether there were criminal charges against the fund manager in the past and so on. Third, and this is really important for the debate on hedge fund regulation, under the current regulatory regime, there is no requirement on hedge funds to disclose some of these basic facts to outside investors under existing legal provisions in most jurisdictions. So you could, unwittingly, be giving your hard-earned money to someone who used to be in jail for grand larceny if you didn’t do your homework. Finally, since hedge funds aren’t required to report their performance to the regulator, they have every incentive to stop self-reporting to data providers and outside investors if they anticipate problems. This means that predicting the probability of a hedge fund collapse using reported hedge fund returns is virtually impossible, since any negative signals are not likely to be made available by fund managers. We need clean, mandatory reports from fund managers to help predict these outcomes.
On balance, it appears that the right level of regulation is to mandate that hedge funds disclose their positions and returns to a regulatory body. Furthermore, prospective investors should legally be able to obtain accurate information about a fund’s characteristics and its manager’s background. Only allowing the regulator access to position and return information sidesteps the concern that hedge funds have about their proprietary investment strategies being disclosed to the public. And allowing investors to easily undertake due diligence about hedge fund managers might make outrageous frauds less likely.
More onerous restrictions such as capital requirements or restrictions on investments like short sales are a step too far, and risk damaging the provision of public goods like liquidity and risky arbitrage. All we need is more information—to help regulators figure out when a hedge fund is likely to become a source of systemic risk or to go under because the manager is a fraud; or to help investors who can make informed decisions about where to put their money. The market operates really well in the presence of such transparency. More seems unnecessary.
—The author is a financial economist at Saďd Business School, University of Oxford