By Sabyasachi Bardoloi, Manager, Pinnacle Research Group, Pinnacle Systems, Inc.

This article takes a historical journey of Hedge Funds and spells out in a nutshell its fundamentals. It indicates the different strategies fund managers adopt to keep themselves adrift. The article further makes a dissection about the proposed regulations on Hedge Funds and points out the two sides of the coin. Finally, the article portrays the skepticism on whether regulating Hedge Funds will really be a stitch in time.

A Historical Sojourn

The story goes back to January 1, 1949, when Alfred Winslow Jones, a professor and Fortune magazine editor, started what is generally considered as the world’s first hedge funds. Despite more than fifty years down the line, Jones’ principle of capital management still holds good while defining hedge funds.

The most radical recipe in Jones’ management system was that he not only bought shares he considered undervalued but also sold shares he considered overvalued, without holding on to the actual securities. In simple terms Jones sold the shares short.

With the rise in share prices on the stock market, he naturally made money on the shares he had purchased, but lost money on the short sells, which became dearer to buy back. Nevertheless, when share prices fell, he made money on these short sells, thus making up for the losses incurred on the purchased shares.

This resulted in a portfolio, which became less dependent on market fluctuations and more reliant on Jones’ own analytical ability in determining individual shares. The term ‘hedge’ was used for a measure aimed to reduce the degree of risk, thus christened hedge fund.

In a Nutshell

There is no exact legal definition of the term "hedge fund" in federal or state securities laws. Hedge funds are fundamentally private investment pools for wealthy, and financially sophisticated investors. A hedge fund in simple terms is thus a private investment partnership that provides high return and offer protection to investors in bearish conditions. The investors’ assets are pooled together and are invested in a variety of securities as well as derivatives.

The very fact of hedge funds being private investment partnerships in the US, the Securities and Exchange Commission (SEC) has limited these entities to 99 investors. Out of these a minimum of 65 needs to be "accredited." Accredited investors are those investors having a minimum net worth of $1 million. Investment in a hedge fund is extremely high and amounts to not less than $1 million. Hedge funds are open only to affluent individuals who are also categorized as "high-net worth clients."

Taking advantage on existing ambiguity in the regulatory system, hedge fund managers’ structure the fund in such a way that they do not come under the microscope of regulatory authorities. Hedge funds in US are required to have less than 99 "high-net-worth clients" in order to avail exemptions to regulations under the Securities Act of 1933, the Securities Act of 1934 and the Investment Company Act of 1940.

However a relatively recent change in the law viz. Section 3(c)7 allows certain funds to accept up to 500 "qualified purchasers." A qualified purchaser must be an individual with at least $5 million in investments or an entity with a minimum of $25 million in investments in order to be able to invest in such a fund.

With the passage of time hedge funds activities widened into other financial instruments and activities. The term "hedge fund" today refers not so much to hedging practices, which hedge funds may or may not apply, as it does to their status as private and unregistered investment pools.

Hedge fund managers characteristically seek absolute positive investment performance. This means that hedge funds target a specific range of performance, and attempt to produce targeted returns, irrespective of the trends prevailing in the stock market. This stands in sharp contrast to investments like mutual funds, where achievement or disappointment is often measured in terms of performance in relation to a stock index, like the NASDAQ.

The primary characteristic of a hedge fund is the fact that it does not depend on market fluctuations to rope in a good return. Its target with regard to return on investment (ROI) is total. A positive return is assured regardless of whether market prices rise or fall. This differs from conventional capital management, where a fund manager generally targets a relative return, by attempting to surpass a comparative index.

The Golden Stratagem

Hedge funds can be termed as unregulated, owned by sophisticated investors and subject to limited disclosure requirements. Hedge fund investing was limited to a handful of wealthy individuals initially, but US financial institutions now allocate a growing percentage of their assets to investments in hedge funds.

This has fuelled strong growth in capital invested in hedge funds, which now amounts to approximately $600 billion. Going by conservative assumptions, the total capital of hedge funds is estimated to reach $1 trillion within two to three years. The widespread use of short selling techniques and over-the-counter derivatives allow hedge funds to assume levels of risk and to adopt positions in financial markets, which can be measured in multiples of their base capital.

Hedge fund managers apply different investment strategies to get positive investment performance, which may include:

  • Short selling i.e. sale of a security you do not own
  • Arbitrage i.e. instantaneous buying and selling of a security in different markets to profit from the price differences
  • Hedging i.e. buying a security to make up for a probable loss on an investment
  • Leverage i.e. borrowing money for investment purposes
  • Investment in bankrupt companies
  • Investment in derivatives like options and futures contracts
  • Concentrating positions in securities of a single issuer or market
  • Investment in volatile international markets
  • Investment in privately issued securities

Depending on the fund’s performance the managers are paid. Performance fees of 20 per cent of profits are universal, along with a fixed annual asset-based fee of 1 to 2 per cent. Since hedge funds are open to limited numbers of financially sophisticated rich investors, and they do not advertise or publicly offer their securities, as such, private hedge funds are usually not required to register with the SEC.

Two Sides of the Coin

As of now, Hedge funds to many an investor is like an oasis of positive returns in the current dry atmosphere of marginal returns. Two clear trends are emerging today that has made the regulation of hedge funds a hot topic.

1. The increasing accessibility of hedge fund products to a wider audience that earlier had no access to this asset class.

2. The volley of news reports highlighting hedge fund scams and frauds, which directly or indirectly makes one ponder and re-think –whether hedge funds should be regulated.

A recent survey conducted by advisory firm Broadgate Consultants indicates that Hedge fund managers hold the view that the Securities and Exchange Commission’s probe into the asset class will bring in more regulation. The survey polled 65 hedge funds with assets up to $25 billion under management.About 80 percent of the respondents feel that the SEC will enact regulations making it mandatory for hedge fund managers to register with the agency as investment advisors.

About 50 percent holds the view that the regulations are necessary, arguing that the growing institutionalization of the industry calls for more transparency.

According to Srinivasan Rajasekaran, Offshore Head, Capital Markets Excellence Center (CMEC), Pinnacle Systems, Inc., - a US-based Capital Markets technology consulting and solutions provider, "SEC should provide broader guidelines for disclosing hedge funds risk profiles and audits. These guidelines should facilitate fair competition among the market players while maintaining the inherent nature of hedge funds."

Hedge funds managers also focus more on fundamental research along with quantitative factors for their investment decisions. Eighty one percent of respondents felt that they are more likely to look at factors like the character of a business; it’s management and earnings trends rather than technical trading patterns before deciding on investment.

According to another report by industry researchers Greenwich Associates, titled Asset Allocation: US Portfolios Adjust to Difficult Markets in 2002, nearly 60 percent of endowments and foundations invest in hedge funds, up from 50 percent last year, and 20 percent of pensions also allocate to the asset class, up from 15 percent last year.

Participants at the SEC’s roundtable forum on hedge funds confirm that $175 million of the $600 billion invested in hedge funds comes from institutions, up from $52 billion in 1998, according to the study.

However the Wharton faculty in a recent report offered a contrary view with regard to regulation. They argue that hedge funds should not be regulated since it would threaten the core of the industry itself. Mr Richard J. Herring, finance professor at Wharton and co-director of the Wharton Financial Institutions Center feels, "the important issue that hasn't been much discussed publicly is the potential implications for the industry if hedge funds do reach a broader market."

He further adds, "It's easy to understand the pressures to make them available to a wider range of clients, but once the issue of protecting consumers enters into the discussion, the regulatory game shifts in a major way." According to Mr Herring, "Regulation is in some sense incompatible with the fundamental role and character of hedge funds," since "hedge funds are designed by law (to operate) with maximum flexibility."

Wharton’s finance professor Richard Marston and director of the George Weiss Center for International Financial Research says, "Congress originally was wise to limit the investor pool to those wealthy enough to be able to make judgments on their own, without the help of SEC regulations." The reasoning is that these individuals and institutions can perform the necessary due diligence themselves and can take on large risks. "The only issue is whether or not that continues to be the case," he adds.

It is quite obvious that absence of regulation makes sense when investors are wealthy but doesn't when people with lesser resources enter the market. Marshall E. Blume, finance professor and director of the Rodney L. White Center for Financial Research at Wharton says, "I don't think people really get terribly upset when somebody with $10 million loses a couple million dollars, but once average investors get hurt, as they will, all bets are off."

Skepticism Fills the Air

The Securities Industry Association (SIA) recently spelt out that more regulation of hedge funds by the SEC might result in higher costs to investors and choke competition. In summarizing the recent SEC roundtable on hedge funds, SIA noted the significant role that hedge funds play for investors and the capital markets. These funds provide investors with a way to expand their holdings to achieve positive returns, and they enhance the liquidity and competence of the financial markets.

The SIA in its letter pointed out two important things.  Firstly, it is unlikely that hedge funds would engage in broad advertisements of their funds even if there were no regulatory restrictions. Secondly, any tightening of accredited investor standards should be accompanied by relaxation of requirements, which delays the flow of information to prospective hedge fund investors.

Another important warning from industry experts is that increased regulation of hedge funds would cut into industry profits and could force the $600 billion industry move offshore. SEC Chairman William Donaldson questioned whether the 5,700 US hedge funds could survive increased regulation by the SEC. "Can this industry sustain the cost" of heightened regulation? He was quoted to have queried recently.

"Transparency, in terms of Hedge funds concentrations and exposures, should be made mandatory. High returns are desired and the fund managers are rewarded. In the absence of penalties for the fund managers when incurring huge losses over leveraged exposures, transparency guides the investor in choosing the right funds and the appropriate risk premium. Investors should have the right to choose any risk profile and have the right to know at any time what the risk level is," feels Mr. Srinivasan Rajasekaran.

Industry members advocate a go-slow approach, saying there is no confirmation of the fact that hedge funds are riskier than other investments, or that fraud is widespread in the industry. However according to SEC chief economist Lawrence Harris, "If we ask for too much transparency, we decrease the profits that hedge funds and other sophisticated traders can make."

Following the detailed dissection on likely regulations in hedge funds, an intriguing predicament that emerges is whether hedge funds regulation will prove to be a stitch in time. It is this critical dilemma that the hedge funds community will soon have to face in the days ahead.

About Pinnacle Systems, Inc.

Pinnacle Systems, Inc. is a technology consulting and solutions provider to Capital Markets firms.

For over seven years, Pinnacle has applied its in-depth domain expertise and offshore development capabilities to the Capital Markets. Pinnacle's Capital Markets Excellence Center (CMEC) TM and its Efficient Delivery Model (EDM) TM successfully deliver cost-effective project based solutions for leading global financial institutions. The company is headquartered in Piscataway, New Jersey, with offices in New York City, and development centers in Chennai, India.

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