Prepared for Members and Committees of Congress
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In an echo of the Robber Baron Era, the late 20th century saw the rise of a new elite class, who
made their fortunes not in steel, oil, or railroads, but in financial speculation. These gilded few are
the managers of a group of private, unregulated investment partnerships, called hedge funds.
Deploying their own capital and that of well-to-do investors, successful hedge fund managers
frequently (but not consistently) outperform public mutual funds. Hedge funds use many different
investment strategies, but the largest and best-known funds engage in high-risk speculation in
markets around the world. Wherever there is financial volatility, the hedge funds will probably be
Hedge funds can also lose money very quickly. In 1998, one fund—Long-Term Capital
Management—saw its capital shrink from about $4 billion to a few hundred million in a matter of
weeks. To prevent default, the Federal Reserve engineered a rescue by 13 large commercial and
investment banks. Intervention was thought necessary because the fund’s failure might have
caused widespread disruption in financial markets. Despite the risks, investors have poured
money into hedge funds in recent years. In view of the growing impact of hedge funds on a
variety of financial markets, the Securities and Exchange Commission (SEC) in October 2004
adopted a regulation that requires hedge funds to register as investment advisers, disclose basic
information about their operations, and open their books for inspection. The regulation took effect
in February 2006, but on June 23, 2006, a court challenge was upheld and the rule was vacated. S.
1402 and H.R. 2586 would reinstate the SEC’s authority. H.R. 2683 would require defined benefit
pension plans to disclose investments in hedge funds. In December 2006, the SEC proposed
raising the “accredited investor” standard—to be permitted to invest in hedge funds, an investor
would need $2.5 million in assets, instead of $1 million.
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Hedge funds are essentially unregulated mutual funds. They are pools of invested money that buy
and sell stocks and bonds and many other assets, including foreign currencies, precious metals,
commodities, and derivatives. Some funds follow narrowly-defined investment strategies (e.g.,
investing only in mortgage bonds, or East Asian stock markets), while others, the so-called macro
funds, invest their capital in any market in the world where the fund managers see opportunities
Hedge funds are structured to avoid SEC regulation. To avoid becoming public issuers of
securities, subject to extensive disclosure requirements, they accept funds only from “accredited
investors,” defined by SEC regulations as persons with assets of $1 million or more. Mutual
funds subject to the Investment Company Act of 1940 must comply with a comprehensive set of
regulations designed to protect small, unsophisticated investors. These regulations include limits
on the use of borrowed money, strict record keeping and reporting rules, capital structure
requirements, mandated adherence to specified investment goals and strategies, bonding
requirements, and a requirement that shareholder approval be obtained (through proxy
solicitation) for certain fund business. An investment company becomes subject to this regulation
only if it has 100 or more shareholders; hedge funds therefore generally limit themselves to 99
investors. (The National Securities Market Improvement Act of 1996 (P.L. 104-290) broadened
this exemption by permitting hedge funds to have an unlimited number of partners, provided that
each is a “qualified purchaser” with at least $5 million in total invested assets.)
Most hedge funds are structured as limited partnerships, with a few general partners who also
serve as investment managers. Hedge fund managers are often ex-employees of large securities
firms, who strike out on their own in search perhaps of greater entrepreneurial freedom and
certainly in search of greater financial rewards. Those rewards, even by Wall Street standards, can
be extremely high. In addition to the return on his or her own capital, the typical hedge fund
manager takes 15%-25% of all profits earned by the fund plus an annual management fee of 1%-
2% of total fund assets.
Estimates of the average annual return earned by hedge funds differ. Some studies find that they
generally outperform common benchmarks such as the Standard & Poor’s 500, but others
conclude that they have lagged. The short life span of many funds creates obvious difficulties for
measurement, including a strong survivorship bias: the many funds that shut down each year are
not included in return calculations. Annual return figures of course conceal a wide variation from
year to year and from fund to fund. In any period, the law of averages dictates that at least a few
funds will do extremely well. These success stories may explain the continued popularity of
hedge funds with investors, despite the high fees that they charge, and the high risk of loss.
Hedge funds are understood to be high risk/high return operations, where investors must be
prepared for losses. Investors who accept the risks are seeking high returns or a means to
diversify their portfolio risk. As long as these investors are sophisticated and wealthy, as current
law requires, hedge fund losses or even failures should not be a public policy concern. However,
a 1998 case provided an exception to this rule.
Long-Term Capital Management (LTCM), a fund headquartered in Connecticut and chartered in
the Cayman Islands, opened in 1994 and produced annual returns of over 40% through 1996. It
was billed as a “market-neutral” fund, that is, its positions were based not on predictions of the
direction of interest rates or other variables, but on the persistence of historical price
relationships, or spreads, among different types of bonds. In 1998, however, turmoil in world
markets, stemming from financial crises in Asia and Russia, proved to be too much for its
computer models: during the month of August 1998 alone, the fund lost almost $2 billion, or
about half its capital. By late September, LTCM was on the verge of collapse, whereupon the
New York Fed stepped in and “facilitated” a rescue package of $3.6 billion cash contributed by 13
private financial institutions, who became 90% owners of the fund’s portfolio.
Why was government intervention needed? The Fed cited concerns about systemic risk to the
world’s financial markets—while LTCM’s capital was a relatively modest $3-4 billion (during the
first half of 1998), it had borrowed extensively from a broad range of financial institutions,
domestic and foreign, so that the total value of its securities holdings was estimated to be about
$80-$100 billion. In addition, the fund supplemented its holdings of stocks and bonds with
complex and extensive derivatives positions, magnifying the total exposure of the fund’s creditors
and counterparties, and making the effect of a general collapse and default difficult to gauge. If
the fund (or its creditors) had tried to liquidate its assets and unwind its derivative positions in the
troubled market conditions that prevailed, the result might have been extreme price drops and
high volatility, with a negative impact on firms not directly involved with LTCM.
Critics of the Fed’s action expressed concerns about moral hazard—if market participants believe
they will be rescued from their mistakes (because they are “too big to fail”), they may take
imprudent risks. To the Fed, however, the immediate dangers of system-wide damage to financial
markets, and possibly to the real economy as well, clearly outweighed the risks of creating
perceptions of an expanded federal safety net.
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In the wake of the Long-Term Capital Management episode, systemic risk emerged as the major
policy issue raised by hedge funds. The funds had demonstrated an ability to raise large sums of
money from wealthy individuals and institutions, and to leverage those sums, by borrowing and
through the use of derivatives, until they become so large that even U.S. financial markets may be
at risk if they fail. Not all hedge funds borrow heavily and not all follow high-risk strategies. But
many do, and there is no reason to think that other hedge funds will not amass positions as large
and complex as LTCM’s. In time, some of them can be expected to suffer equally spectacular
losses. The systemic risk concerns may be summarized as follows:
• failing funds may sell billions of dollars of securities at a time when the liquidity
to absorb them is not present, causing markets to “seize up”;
• lenders to hedge funds, including federally insured banks, may suffer serious
losses when funds default—LTCM raised questions about their ability to evaluate
the risks lending to hedge funds;
• default on derivatives contracts may disrupt markets and may threaten hedge
fund counterparties in ways that are hard to predict, given the lack of
comprehensive regulatory supervision over derivative instruments; and
• since little information about hedge fund portfolios and trading strategies is
publicly available, uncertainty regarding the solvency of hedge funds or their
lenders and trading partners may exacerbate panic in the markets.
LTCM illustrates the dangers of hedge fund failure. However, the funds’ successes can also worry
policymakers and regulators. Particularly in foreign exchange markets, manipulation by hedge
funds has been blamed as a cause of instability (e.g., the European currency crises in the early
1990s and the Asian devaluations of 1997-1998). Hedge funds and other speculators can borrow a
currency and sell it, hoping to profit if the currency is devalued (allowing them to repay with
cheaper money). If the size of these sales or short positions is significant in relation to the target
country’s foreign currency reserves, pressure to devalue can become intense. To defend the
currency’s value may call for painful steps such as sharp increases in domestic interest rates,
which have negative effects on the stock market and economic growth.
In the United States, which has not been the target of such speculative raids, many argue that
blaming hedge funds for crises is like shooting the messenger who brings bad news, and that
speculators’ profit opportunities are often created by bad economic policies. The effect of
speculation on price volatility is an unresolved question in finance. While there has never been a
conclusive demonstration that speculation causes volatility, the two are frequently observed
together. Hedge funds, as the most visible agents of speculation in today’s global markets, are
looked upon by some regulators and market participants with a fair amount of suspicion.
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In April 1999, the President’s Working Group on Financial Markets, which includes the Fed, the 2
SEC, the CFTC, and Treasury, issued a report on hedge funds. The report cites the LTCM case as
demonstrating that a single excessively-leveraged institution can pose a threat to other institutions
and to the financial system, and found that the proprietary trading operations of commercial and
investment banks follow the same strategies in the same markets as the hedge funds, and they are
much larger and often more highly-leveraged. The general issue, then, is how to constrain
The Working Group concluded that more disclosure of financial information by hedge funds was
desirable. The report recommended that large funds be required to publish annual disclosure
statements containing a “snapshot” of their portfolios and a comprehensive estimate of the
riskiness of the fund’s position, and that public companies and financial institutions should
include in their quarterly and annual reports a statement of their financial exposure to hedge funds
and other highly-leveraged entities.
In 2003, in response to continued rapid growth in hedge fund investment, an SEC staff report 3
recommended that hedge funds be required to register as investment advisers. The staff set out
several benefits to mandatory registration:
• funds registered as investment advisers would become subject to regular
examinations, permitting early detection and deterrence of fraud;
• the SEC would gain basic information about hedge fund investments and
strategies in markets where they may have a significant impact; and
• the SEC could require registered hedge funds to adopt uniform standards and
improve disclosures they make to their investors.
On October 26, 2004, the SEC adopted (by a 3-2 vote) a rule to require hedge funds to register 4
under the Investment Advisers Act. The rule was controversial: opponents argued that hedge
fund investors are sophisticated and know the risks, that the SEC already has authority to pursue
hedge fund fraud, that systemic risk concerns are overstated, and that instead of trying to
circumscribe hedge funds, the SEC ought to be encouraging registered mutual funds to adopt
hedge fund investment techniques.
The regulation fell short of what some critics of hedge fund behavior would have liked to see.
The SEC would still not be able to monitor hedge fund trading in real time, and the possibility of
another LTCM remains. However, the SEC explicitly decided against this course—the 2003 staff
report found “no justification for direct regulation” and the adopted rule had “no interest in
impeding the manner in which a hedge fund invests or placing restrictions on a hedge fund’s
2 Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, Washington, April 28, 1999.
3 U.S. Securities and Exchange Commission, Implications of the Growth of Hedge Funds: Staff Report to the U.S. SEC,
Sept. 2000, at http://www.sec.gov/news/studies/hedgefunds0903.pdf.
4 See http://www.sec.gov/news/press/2004-95.htm.
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ability to trade securities, use leverage, sell securities short or enter into derivatives 5
The rule took effect on February 1, 2006, and some basic information on registering hedge funds
appeared on the SEC website. However, on June 23, 2006, an appeals court found that the rule
was arbitrary and not compatible with the plain language of the Investment Advisers Act, vacated
it, and returned it to the SEC for reconsideration. SEC Chairman Cox instructed the SEC’s
professional staff to provide the Commission with a set of alternatives for consideration.
Another issue involves the “retailization” of hedge funds.6 As noted above, all fund investors
must meet an “accredited investor” standard: they must have incomes of at least $200,000 and
assets of $1 million. This threshold was established in the 1980s, and a much larger fraction of the
population now meets the test, particularly since the $1 million includes the value of the
investor’s residence. The SEC has been concerned that relatively unsophisticated households may
be putting their money in hedge funds, encouraged by market developments such as the
introduction of funds-of-hedge funds, which accept smaller investments than traditional funds.
A related investor protection issue arises from the fact that pension funds and other institutional
investors are placing more of their money with hedge funds, meaning that unsophisticated
beneficiaries may be unwittingly at risk of significant hedge fund-related losses, if the plan
fiduciaries are not prudent and cautious.
On December 13, 2006, the SEC proposed a regulation that would raise the accredited investor
threshold from $1 million to $2.5 million in assets (excluding the value of the investor’s home). If
adopted, the rule would significantly reduce the pool of potential hedge fund investors, but would
not be expected to have a strong impact on the largest funds, which do not depend on “mere”
millionaires. The SEC received many unfavorable comments from investors who meet the current
standard but would be excluded under the new limits: these investors do not wish to be protected
from risks that the SEC might view as excessive.
In February 2007, the President’s Working Group issued an “Agreement Among PWG and U.S. 7
Agency Principals on Principles and Guidelines Regarding Private Pools of Capital.” The
document expresses the view that policies that support market discipline, participant awareness of
risk, and prudent risk management are the best means of protecting investors and limiting
systemic risk. The Agreement does not call for legislation to give regulators new powers or
authorities to regulate hedge funds.
In the 109th Congress, the House passed H.R. 6079 (Representative Castle), which directed the
President’s Working Group to study the growth of hedge funds, the risks they pose, their use of
leverage, and the benefits they confer. The Senate did not act on the bill.
6 Instead of the traditional minimum investment of several hundred thousand, some funds now allow investors to put in
as little as $10- or $20,000. Hedge funds-of-funds are increasingly marketed not just to the “super-rich” but to the
merely “mass affluent.”
7 See http://www.treasury.gov/press/releases/reports/hp272_principles.pdf.
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In the 110th Congress, H.R. 2586 (Representative Capuano) and S. 1402 (Senator Grassley) would
reaffirm the SEC’s authority to require hedge funds to register under the Investment Advisers Act,
reversing the 2006 Goldstein decision.
H.R. 2683 (Representative Castle) would require defined benefit pension plans to disclose their
investments in hedge funds in their annual reports.
Specialist in Financial Economics
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