Research Proposal on "Hedge Fund Regulation"

Research Proposal 18 pages (4816 words) Sources: 5

[EXCERPT] . . . .

Hedge Fund Regulation

The purpose of this document is to examine hedge fund regulation shift specifically as related to SEC regulations from systemic fraud fears begun in 1998 by the Failure of Long-Term Capital Management. This work will further examine the protection fears of investors resulting from the Bernie Madoff scandal and will examine as well systemic risk fears in recent financial crisis with emphasis on hedge funds. Toward these ends this work will examine online documentation available via the Internet

A 'hedge fund' is "a private investment vehicle that is less regulated than traditional investment companies." (Shadab, 2007)

Shadab explains that the hedge fund is thus named due to the role the fund plays in 'hedging' "against downturns in more conventional investments." (2007)

Historically, hedge funds have "taken investment positions that are relatively uncorrelated with broader financial markets or that may be in opposition to broader markets" (Shadab, 2007i

However, in more recent years hedge funds have also undergone expansion "to cover funds that employ very complex investment strategies." (Shadab, 2007)

Hedge funds were at one time "relatively obscure" and as well federal statute mandated that these types of funds were reserved for only the wealthiest of investors however, hedge funds presently are stated to manage "nearly $1.5 trillion in assets for investors that include pension funds and university endowments." (Shadab, 2007)

The benefits to the economy of hedge funds include mitigation of price downturns, and as well hedge funds bear risk that otherwise would not be taken and result in more liquid securities as well as "ferreting out inefficiencies." (Shadab, 2007)

These benefits are enabled due to less stringent regulation of hedge funds which are less restricted in relation to the use of derivatives and leverage and there are greater incentives to do so since they are under no disclosure requirement in terms of their strategies or holdings to the public. Hedge funds are generally exempt from the requirements of registration and disclosure under federal securities laws and this includes the Securities and Exchange Act of 1934, the Investment Advisers Act of 1940, and the Investment Company Act of 1940. (Shadab, 2007, paraphrased)

There is also no prohibition from "leveraged trading, short-selling, or concentrated investing." (Shadab, 2007) Shadab states that qualification for the exemptions requires that hedge funds do not advertise and that they only accept investments from wealthy investors and large institutions. There are however, government regulation and oversight to which the hedge funds are subject and included are federal securities law which "...prohibits hedge funds from fraud and insider trading." (Shadab, 2007)

Hedge funds are under a requirement of making disclosures of a substantial nature to potential investors "in order to discharge fiduciary duties and avoid running afoul of antifraud rules prohibiting misleading statements' and omissions." (Shadab, 2007)

Hedge funds must report any "nontrivial holds in public companies" to the SEC as well as reporting "all of their stock holdings on a quarterly basis if the fund has more than $100 million invested in public companies." (Shadab, 2007)

It is stated to be common for a fund to trade futures or commodity options contracts which results in the funds being under the CFTC's scrutiny and as well for a fund to have 25% or even more of its equity assets that are owned by a qualified employee benefit plan which results in the fund ensuring compliance with the Employee Retirement Income Security Act (ERISA). Additionally, Shadab reports that indirect regulation applies to hedge funds and that "federal treasury regulations limit the ability of banks to lend hedge funds, and Regulation '1' of the Federal Reserve Board likewise limits securities brokers-dealers..." And banks are also required to comply "with minimum risk-based capital requirements under the Basel capital accord and are subject to inspection by bank supervisors for exposures to risk." (Shadab, 2007)

Recent Reports

The work of Huang (2009) entitled: "Outlook for Global Hedge Funds Positive" states that according to observers "the outlook for global hedge funds appears rosy with U.S. pension funds likely to drive growth." The challenge identified by Huang (2009) is "how regulations for the industry evolve and are implemented." It is reported that a belief exists that the implementation of tougher policies "will be tricky as this could lead to funds relocating to countries with friendlier regulations." (Huang, 2009)

The report states further that there is a demand on the part of investors for "more operational transparency and better risk management in the aftermath of the financial crisis. Tighter regulations are expected in the hedge funds industry, and some observers said defining and implementing such policies will not be straightforward." (Huang, 2009)

Madoff Scandal and Investor Protection Fears

It was reported by Bloomberg in the December 11, 2008, article entitled: "Madoff Charged in $50 Billion Fraud at Advisory Firm" that Bernard Madoff, found and president of a New York firm "that invested funds for wealthy individuals, hedge funds and other institutions, was charged with operating what he told employees was a long-running $50 billion Ponzi scheme in what may be one of the largest frauds in history." (Glovin and Scheer, 2008)

The report states that Madoff was arrested by the FBI and appeared before a U.S. Magistrate Judge in Manhattan federal court. Charges against Madoff included a single count of securities fraud. It is reported that Madoff was released on a $10 million bond which his wife guaranteed. The SEC filed a complaint in the Manhattan federal court accusing Madoff of "a multi-billion dollar Ponzi scheme that he perpetrated on advisory clients of his firm." (Glovin and Scheer, 2008)

The SEC is stated to be seeking emergency relief for investors which includes a freeze on assets and the appointment of a receiver for the firm. All of this is stated to have come to surface when two of his staff members requested a meeting with Madoff and he admitted that "he was 'finished', that his advisory business is 'all just one big lie' and 'basically, a giant Ponzi scheme." (Glovin and Scheer, 2008) the government reported that the business "had been insolvent for years with losses of about $50 billion..." (Glovin and Scheer, 2008)

Greenwich Associates reports in the work entitled: "Hedge Funds Under the Microscope: Examining Institutional Commitment in Challenging Times"

reports that institutional investment has been a major factor in the phenomenal growth of hedge funds over the past two decades. However, despite investor expectations of enhanced diversification and absolute returns with a low correlation to broad markets, hedge funds, with a few exceptions were not immune to the damage wreaked by the ongoing global financial crisis. Most hedge fund strategies produced double-digit losses in 2008, making it the worse year on record for hedge fund performance." (Greenwich Associates, 2008)

In 2008, it is reported that the majority of hedge fund strategies produced "double-digit losses...making it the worst year on record for hedge fund performance. Hedge funds also saw approximately $70 billion in redemptions between June and November as many institutional hedge fund investors headed for the sidelines or rebalanced their portfolios." (2008)

Greenwich Associates reports that it is against this tumultuous backdrop, [that] the SEI Knowledge Partnership collaborated with Greenwich Associates to conduct a global survey of institutional investors on their views concerning hedge fund investing. Initially, 95 investors in Continental Europe, the United Kingdom (U.K.), and the United States (U.S.) were interviewed in August of 2008. As the crisis deepened, SEI re-interviewed 32 participants from the original sample in November to help gauge the impact of market turmoil on institutional attitudes, policies and plans concerning hedge funds." (2008)

Key findings of the survey are reported as follows:

(1) Institutions have been strengthening their commitment to hedge fund investing. In fact, 62% of first-round respondents said they had increased their allocations to hedge funds in the last two years, with 29% maintaining the same levels. They reported current hedge fund allocations averaging 7.4% of total portfolio assets, slightly lower than the average target allocation of 8.4%. Moreover, 44% said they planned to increase target allocations significantly over the next three years, and nearly half expected to maintain allocations.

(3) Thus far, most institutions are not backing off from their long-term commitment to hedge funds. However, the potential impact of the Madoff allegations, which were revealed in December, has yet to be fully determined. Three out of four investors re-surveyed in the November round of interviews said they had taken "no action" in response to the crisis. When asked why, 83% of those taking no action indicated their commitment to hedge funds has remained unchanged. The remaining respondents had investments that were subject to lock-up provisions and could not be withdrawn in any case. Although the percentage planning to increase target allocations dropped significantly between the first and second surveys, only one institution reported lowering its target hedge fund allocation since the first-round survey. More importantly, 85% of the second-round interviewees said they plan to maintain or increase their target allocations.

(3) a desire for diversification is the most important reason… READ MORE

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