Private Investment Funds: Hedge Funds' Regulation by Size

Authors

Tamar Frankel, Boston University School of LawFollow

Author granted license

Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International

Document Type

Article

Publication Date

Spring 2008

ISSN

0277-318X

Publisher

Rutgers School of Law - Camden

Language

en-US

Abstract

This Article focuses on hedge funds-a species of private investment funds. These funds appeared in the 1950s and remained active but small. Then, in a fairly short period, they grew enormously to over $1.5 trillion, although the estimates vary.¹ Hedge fund managers engage in more than twenty-five different categories of investment strategies.² Since 2002, the number of hedge funds has more than doubled to an estimated 9,000 funds,³ and their assets have grown by 400% to an estimated $1.4 trillion since 1999.⁴ Other estimates are higher, suggesting current hedge fund assets at $2 trillion and their number worldwide at 13,000, although the United States market accounts for 70% of the funds' assets. ⁵ The different estimates may be due to the fact that these funds are not required to report as much as other regulated pools of assets are, that the funds are absorbing assets globally, and that their investor and lender base has grown. The number of funds does not represent their asset concentration, however. "The average size of a hedge fund, however, just exceeds $100 million. Thus, ten percent of the hedge funds hold about ninety percent of the total hedge fund assets." ⁶ Hedge fund managers engage in many different investment strategies.⁷ But their size has increased by borrowing and by a variety of indirect leveraging techniques, such as short positions, futures, repurchase agreements, options, and other derivative contracts.⁸ In addition, there is also a growing concern over the retailization of hedge funds. ⁹ Hedge funds have reached small investors' money indirectly by attracting mutual funds and pension funds. ¹⁰

Some hedge funds have produced enormous profits for their investors and their managers. Other funds have suffered significant losses due to fraud, ¹¹ and some have generated devastating losses by speculation and risky structures. ¹²

This symposium poses the questions of whether private funds should be regulated, and whether the Securities and Exchange Commission ("SEC") should increase the level of its regulation over these funds. The attempts of the SEC to regulate the managers of hedge funds have been only partially successful. ¹³

More importantly, the freedom of hedge funds from regulation is important to our financial system. ¹⁴ The fund managers are the mavericks, the innovators and risk-takers. They offer experimental and innovative approaches. Some of these approaches contribute to the efficiency of the markets. For example, a number of hedge funds trade in "miss-priced assets" and offer alternative investments to pension funds. These funds perform very well in market downturns. ¹⁵ Some funds may provide early danger signals, which are helpful to the markets and the regulators; that is, so long as these funds do not threaten to undermine the entire financial system. These funds did not threaten the financial system. That is when the funds remained small and investors did not clamor to invest in them. So long as they remained unique and out of the ordinary actors they did not endanger the system.

While there is a need to limit the impact of hedge funds on the financial system, I suggest that this goal should be achieved by regulating the size of these funds. Rather than controlling the funds' actions or their actors, it is the source of these funds' assets that requires control. Hedge funds should remain free of additional regulation if they remain small in terms of the amounts that their lenders invest in them. Thus, the necessary regulation of today's hedge funds should focus on how hedge funds grow in terms of assets under management, and who enables them to grow in this way.

This Article suggests that the lenders - the banks and large institutional investors, as well as funds of funds - should be regulated. The regulation of these institutions should induce them to limit the amounts they offer to finance hedge funds by requiring the financing to be kept on their books, prohibiting the sale of this financing and perhaps by increasing the loan loss reserves; our existing philosophy and method of regulation, falling within the duties of these financing institutions to their savings investors.

This Article is organized as follows: Part I outlines the regulation of investment companies and the exceptions that shelter hedge funds from some regulation. Part II examines the source of hedge funds' growth in the past few years. Part III describes the fraudulent behavior of some managers of large hedge funds and the impact of their behavior on the financial system. Part IV suggests principles on which regulation should be based. It emphasizes that regulation aims not only, and perhaps not mainly, at protecting investors as much as it aims at protecting the financial system. Regulators should keep hedge funds small and relatively free to take risks. The main lenders and institutional investors should be regulated by reducing their incentives to finance hedge funds.

Recommended Citation

Tamar Frankel, Private Investment Funds: Hedge Funds' Regulation by Size , in 39 Rutgers Law Journal 657 (2008).
Available at: https://scholarship.law.bu.edu/faculty_scholarship/3094