Hands Off Hedge Funds

Sunday, August 6, 2006

EIGHT YEARS AGO the collapse of a hedge fund named Long-Term Capital Management triggered fears of international financial instability. Since then, hedge funds have quadrupled the volume of money they manage and account for perhaps 30 percent of trading on U.S. stock markets. Meanwhile, the regulatory response has been confused. Two years ago the Securities and Exchange Commission decided, in a controversial 3-to-2 vote, to require hedge fund managers to register and submit to inspections. This policy was opposed by Alan Greenspan, Fed chairman at the time, and got a cool response from regulators at the Treasury Department. In June a federal court vacated it.

Having inherited this mess, SEC Chairman Christopher Cox is pondering how to fix it. His objectives should be to mend fences with his fellow regulators and to tread lightly on this industry. Hedge funds, which exist to come up with futuristic trading strategies that others haven't tried, are the classic example of an innovative industry with which regulators can't keep up. Pretending to conduct meaningful oversight is worse than conducting none at all: It dulls investors' incentives to monitor the risks of putting money into hedge funds.

There are three types of argument in favor of regulating hedge funds, and none is persuasive.

The first invokes systemic risk: If a hedge fund collapses, the banks that lent to it may collapse, too, causing a chain reaction through the financial system. This danger is real, but the banks that lend to hedge funds have a strong incentive to manage it by limiting their exposure to hedge funds and by monitoring the risks that the funds take. Since the Long-Term Capital debacle, this is what banks appear to be doing. Regulatory prodding has encouraged the banks to get smarter, though in some cases the rules perversely permit hedge funds to borrow more if they take on extra risk -- an example of how oversight of this complex industry can backfire.

The second argument for regulating hedge funds is that they are havens of insider trading and other sorts of illegal manipulation. It's true that some prominent cases of fraud involve hedge funds, but this isn't surprising given their size. The law already empowers regulators to go after hedge fund managers who commit financial crimes. It's not clear that extra regulations would add much.

The third argument for regulation concerns investor protection. The SEC suggests that by registering and inspecting hedge funds it can reduce the danger that investors will lose money. Some hedge fund managers are happy to accept this line: To reassure anxious clients, some choose to register with the SEC anyway, and they calculate that submitting to mild regulation now may be smarter than waiting until the political storm that would follow the scandalous blowup of a crooked player in their industry. But this is a case of hedge funds and their customers trying to ensure their reputations by gaining a regulatory seal of approval. The regulators should decline to become a security blanket.

There is one fix that does make sense, and Mr. Cox has proposed it. Hedge fund customers are currently required to have personal wealth of at least $1 million -- a relatively low threshold given that home equity counts toward it. But hedge funds make sense only for families richer than that: They have minimum investment requirements of $500,000 or more and are sufficiently risky that they should represent only a small part of a portfolio. The $1 million hurdle should at least be doubled.

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