Jose D. Roncal
After years of side-stepping oversight and regulation, the hedge fund industry is about to change. Even though it’s not clear what role hedge funds played in the current economic crisis, the lackluster returns and lack of transparency have stacked the cards against the industry. Then there are the scandals surrounding AIG’s questionable business decisions, which included making hedge fund bets against the housing market—news that may amount to one more nail in the coffin.
For years, there’s been a hew and cry for more regulation and transparency for hedge funds. But hedge fund managers have held their ground, even when the SEC put forth a proposal that would have required the funds to register with the agency and be subjected to close scrutiny. But a federal court decided that the SEC didn’t have the authority to impose such rules.
Today, the move toward regulation is getting some traction in the U.S. Congress, with ideas that could include giving the Federal Reserve broader oversight, limiting hedge funds’ ability to borrow money and even curbing some of the higher-risk bets.
Hedge funds have been on a growth rampage since the early 90s as more and more deep-pocketed investors looked for ways to beat the market. There are now about 10,000 funds controlling over $1.5 trillion in assets. Things were going fairly smoothly, until the tide turned leaving hundreds of money-losing funds and stunned investors in the wake. The average hedge fund lost nearly 20% in 2008, maybe not as bad compared to the over all market returns, but when even hedge funds fail to hedge, it adds to the panic on Wall Street.
Traditionally, hedge funds only offered their high-rolling investors vague descriptions about their strategies. Their argument was that in order to give them an edge, they had to keep their trading schemes under wraps. But the Madoff fiasco will undoubtedly add fuel to the fire for more transparency, and if it doesn’t it should.
Even though Madoff’s operation was not a hedge fund per se, it did operate with strict secrecy and Madoff also operated a money for “funds of funds,” a hedge fund off-shoot. Now, more hedge fund investors are demanding information about how their money is used and who actually holds the securities in the fund
We do know that part of the big hedge fund losses in 2008 were a result of the ban on short sales—these are bets on market declines and are an essential factor in many hedge funds’ investment strategies. With short selling disallowed, the liquidity in several markets quickly dried up.
No one has ever argued that hedge funds are not risky business, but even though they have gotten a reputation for being major contributors to the current economic crisis, there really is not much evidence they are the primary villains.
We think most of the blame belongs to the investment banks that began dealing in more complex financial packages, over-leveraging their bets, and even acting as their own hedge funds. You could also blame it on the big push for home ownership, which encouraged banks to loan to buyers with bad or worse credit.
Hedge funds were originally only offered to qualified investors, the rich and famous who had money to speculate on high-risk ventures—in other words, money to burn. If these are the individuals who want to continue playing the game, more power to them. After all, the country was built by speculators. But stiffer government regulation might at least shelter innocent bystanders that have recently become entangled in hedge funds, like university endowments, charities, and pension plans—the large institutions that ventured into precarious hedge fund territory taking their unwary investors’ money with them.
In spite of all the water cooler chatter and speculation, we haven’t heard of many bona fide economists who are predicting that the industry will evaporate entirely. Even with expected future regulations, there will always be those who will be pulled in by the promise of extraordinary gains—at least for as long as hedge funds can continue to use strategies that mutual funds and other investment pools can not use.
There are no real specifics about what may be coming, but we’re guessing that if new regulations are imposed, they will be staged in, first with tougher disclosure requirements followed by other new rules that will be draws up as red flags surface.
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