It is time to get serious about hedge fund risk. This, however, is not the usual argument for more regulation of hedge funds. Here is a contrarian view: the best course for our capital markets may actually be in the other direction. Perhaps hedge funds need to be deregulated, breaking down the wall that restricts hedge fund investing only to the wealthy.
All investors — not just rich ones — should have access to the superior investing and diversification potential of hedge funds. Deregulating these opaque entities will also bring these funds out into the open, helping regulators monitor systemic risk, where the real focus of hedge fund supervision should be.
What do I mean? Right now, hedge funds are walled off from the public by the Investment Company Act and rules created by the Securities and Exchange Commission. For the most part, they’re available only to “sophisticated investors,” defined by the S.E.C. as those with more than $1 million in assets or individual income exceeding $200,000 in each of the last two years. The S.E.C. has periodically proposed raising this bar to $2.5 million in assets; hedge funds often lift it even higher, to a net worth of more than $5 million.
This is why I cannot use my Charles Schwab account to buy into a hedge fund. Given the public misunderstanding of what these firms are and do, this is considered a good thing. Common wisdom says that hedge funds are too complicated and risky for Main Street.
This is a myth.
Hedge funds provide important diversification for their investors. They balance other investments and reduce overall risk. For example, the Hedge Fund Research Weighted Composite Index, a measure of aggregate hedge fund returns, rose 14.1 percent this year through August. This was after a negative 19.03 percent return in 2008.
That sounds bad — until you learn that the Standard & Poor’s 500-stock index returned about 13 percent and a negative 38.49 percent for the same respective time periods. Clearly, hedge funds came out ahead.
(Some specific types of hedge funds have done even better: the Hedge Fund Research Multi-Strategy Index, which tracks multi-strategy funds, returned 19 percent for this year through August and negative 20.3 percent last year.)
Hedge funds also provide what the industry calls absolute returns. Mutual funds aim simply to beat their market benchmark, meaning they’ll define themselves as successful if they drop 14 percent while the S.& P. 500 falls 15 percent. By contrast, hedge fund managers are not paid until they generate positive returns — that is, they actually make money.
“But what about the risk?” you might ask.
Hedge funds do more than diversify investment portfolios. They live up to their name: they (ideally) hedge their returns so that they are less volatile. True, some funds have failed. But General Motors went bankrupt, and we’re not about to halt the stock market.
According to Hedge Fund Research, about 16 percent of hedge funds closed last year. That may sound like a lot, but it does not mean that all that capital was wiped out. Even investors in Long-Term Capital Management and Amaranth Advisors, two of the most spectacular hedge fund flameouts, got back 10 percent and 35 percent of their money, respectively.
The overwhelming majority of hedge fund liquidations are orderly runoffs that result in some loss for investors, but not an entire loss of their principal investments. Before the financial crisis, one study found that the majority of hedge fund closures stemmed from operational risk, not investment failure. Funds that did fail because of their investment performance collapsed because of liquidity issues and investor withdrawals.
This does not mean that investors should put all of their money in one hedge fund, just as they shouldn’t invest only in General Motors. But hedge funds are an important part of the diversified investment portfolio that financial experts recommend.
Finally, there is the perceived complexity of hedge funds. Are these firms really more arcane than the complicated investment banks of today like Goldman Sachs? The truth is that public hedge funds are no more complex than many of today’s public companies.
The S.E.C. has tried again and again to restrict public investment in hedge funds, but the problem is that the markets are moving too fast. The financial revolution and demands of investors mean that hedge fund-like products that are being marketed to the general public are being created, legally. Thus, we have the IndexIQ’s Hedge Multi-Strategy Tracker Exchange-Traded Fund. According to IndexIQ, the fund is meant “to replicate, before fees and expenses, the returns of the IQ Hedge Multi-Strategy Index,” which encompasses a variety of hedge fund investment techniques.
If you want to build your own hedge fund, you can now buy other exchange-traded funds or exchange-traded notes for oil, currencies and various commodities. My favorite is the iPath DJ-UBS Coffee Subindex Total Return E.T.N., which tries to replicate an index of coffee future contracts. Pretty complex, no?
Because of another regulatory loophole, the S.E.C. allows the public listing of hedge fund firms like the Fortress Investment Group and Och-Ziff Capital Management — but not the funds they run. Of course, these firms draw their income from these unlistable hedge funds, so an investment in Och-Ziff’s stock is similar to a direct investment in one of its funds. But holding Och-Ziff stock is even riskier than investing in one of its funds, since limited partners can have their capital returned if the fund runs negative returns. Stockholders in the firm in the same situation receive nothing.
The real issue with hedge funds is systemic risk: the possibility of another Long-Term Capital, when one fund almost took down the whole financial system. Regulators must have the tools to prevent this kind of danger.
Having hedge funds report their investments to the S.E.C. (or another regulator) and limiting systemic risk through capital requirements is now before legislators. But making these firms more accessible to average investors would be a natural incentive to bring them further into the light. The market process would help obtain disclosure about their investments. It would also offer an alternative to the roughly $10 trillion mutual fund industry, which all too often fails to beat its benchmark indexes.
Because why shouldn’t public retail investors get the same benefits as private wealthy investors?
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