Regulating Hedge Funds

            Hedge funds have been in the news this year.  They made more news on May 10^th when the Dow Jones Industrial Index, a measure of the health of the stock market, lost over 100 points.  Insiders attributed much of the drop in market prices to rumors of hedge fund losses.

            Should the government regulate the trading activity of hedge funds to reduce market volatility?  No, but the government should look at the publicly traded institutional investors that lend or contribute money to the funds.

            A hedge fund has three characteristics.  First a hedge fund invests large sums of money with very short-term return horizons.  It is “fast money” that when in, soon wants out – at a profit.  Second, the money is pooled from a small number of wealthy individuals and institutional investors.  A hedge fund is a “private” organization, free from regulation under the Investment Company Act of 1940.  It is not, therefore, a mutual fund, which is heavily regulated by the Act. The funds are secretive and many are headquartered offshore. And third, a hedge fund uses extreme leverage to maximize returns.  A fund borrows heavily from banks and others to add to the size of its investment positions.  If the returns on a given investment (say 10%) exceed the interest rates owed the banks on the borrowed money (say 8%), the hedge funds returns exceed the investment returns (they make 18% or so rather than the 10%). 

            On May 10^th rumors spread that the hedge funds had taken heavy losses in their investments in stock and bond positions in General Motors.  According to the rumor, several large funds had shorted the stock and were long in the bonds.  If so, the funds bet wrong.  A tender offer for GM stock by Kirk Kerkorian kept stock prices high and a downgrade of the bonds’ to “junk” status by credit rating agencies dropped the bond prices.

            Because hedge funds are privately held they are not required to make information about their activities public.  The lack of information fueled the rumors.  Reporters and market professionals scrambled to phone hedge funds and check on the source of the rumors.   

            The rumors caused sharp price declines in the stock price of investment banks, which are publicly-held and publicly-traded.  Traders connected the banks to the hedge funds because it was also rumored that the banks had lent money to the funds to enable the funds to leverage their positions in GM.  It was the drop in the price of the banks’ stock that led to the drop in the Dow Jones Index.

            The events of May 10^th will no doubt increase the pressure on the SEC and Congress to regulate hedge funds.  They should resist.  Regulation will not only drive more of the headquarters of hedge funds offshore but drive their investment activity offshore as well.  The London Stock Exchange will be the winner and our stock exchanges the losers.

            The SEC can, however, reduce the effect of hedge fund rumors on publicly-traded banks in the

United States

.  The SEC can require those institutions that are publicly-traded to disclose more detail on their exposure to specific hedge fund positions.  Investors will be able to better price the bank’s exposure to changes in market conditions that affect their hedge fund clients.  An increase in regulation should, therefore, focus on the public lending institutions that deal with hedge funds, not the hedge funds themselves.