A popular perception is that the community of investment managers responsible for so-called private pools, i.e., hedge funds, is lightly regulated, Unfortunately, this phrase is not particularly informative or even accurate.
While it is true that the five-month-old attempt by the Securities and Exchange Commission to assert its mandatory oversight over private capital pools was invalidated last June by the U.S. Court of Appeals for the District of Columbia, many hedge funds have been regulated by the SEC on a voluntary basis for years. Other managers, by virtue of their investment strategies, are obligated to register with different regulatory bodies including the Commodity Futures Trading Commission and the National Futures Association. Hedge funds have always been subject to the civil and criminal statutes that govern our nations commercial activities, including the most recent legislation (Sarbanes-Oxley and the Patriot Act) concerning fraud and money laundering. In addition, hedge fund transactions are subject to scrutiny by the major prime and clearing brokers and through them, the Federal Reserve, the National Association of Securities Dealers and the Financial Services Authority, the U.K. equivalent of the SEC.
So the question really is not whether the hedge fund industry is regulated, lightly or not, but whether it is being adequately regulated by the various public and private agencies that should have oversight authority.
For this important question to be answered efficiently, two key predecessor questions need to be answered: 1) With which risks should the regulatory authorities be concerned? And 2) what information needs to be gathered in order for an adequate regulatory regime to be constructed?
The answer to the first question is systematic risk, particularly those systematic risks that can catastrophically affect any individual firm such as we have seen at Amaranth Advisors LLC, or those that through any collection of correlated firms can affect the financial system in general. It is this central issue, systematic risk, for which the United States has not yet created an oversight mechanism for hedge funds that is even up to the task of compiling comprehensive data, which is the predecessor of setting and monitoring standards.
If it is true that investor protection is the ultimate goal of any regulatory construct, there is no better way to accomplish this goal than to monitor, and then lower, systematic risk exposure, if at all possible.
It should be by now abundantly clear that the hedge fund industry needs to work in good faith with the SEC to create a mandatory and universal regulatory regime that is fair and transparent, and can actually serve some public policy good. In fact, there is a successful regulatory model in operation right now in the United Kingdom under the auspices of the FSA.
The distinguishing attribute of the U.K. system of hedge fund regulation is that it has as its base purpose macro information disclosure and risk identification of companies that place themselves in a fiduciary position, whether in private or public form. This is a subtle but important difference from the approach that the SEC seemed to be taking, that of fraud detection, prevention and potential punishment. The fact remains that as ugly as fraud is, its prevalence and impact pale in comparison to non-fraud-related market risk factors.
Some suggestions: First, get rid of form ADV, required of investment advisers registered with the SEC. This form is outdated even for the 70-year-old mutual fund industry. It is barely applicable, much less adequate, for the newer hedge fund structure. Luckily, the pension consultant industry has created an information disclosure mechanism that has been specifically designed to gather basic information for manager review: It is called a request for proposal. The SEC need not reinvent a process that has been blazed for them by careful and responsible fiduciaries.
Second, focus the regulatory review process on disclosure and macro process management, not micro management details like, for instance, e-mail retention. There is not nearly enough basic information about the hedge fund industry in its entirety and in a single place, such as how many hedge funds exist. We dont know, and need to know, the most recent value of its capital and asset base. We should know exactly the names of the prime brokers for each fund. We should know how frequently the assets are marked to market and by what process. We should know how much leverage is being used in the system and how much it varies. We should know a lot more about historic performance. The hedge fund industry and regulating authorities should be working together to acquire this information.
The fact that the United States does not have this basic information is certainly a scandal. If all hedge funds were required to register in a non-invasive way and in a manner that frankly doesnt scare the pants off a thoughtful manager who is rightly concerned about random, potentially capricious and therefore dangerous enforcement activities, then we all could have a data base that could give public policy-makers a basic level of industry understanding that can be used for a greater public good.
Paul Ullman is CEO of Highland Financial Holdings Group LLC, a New York-based hedge fund registered as an investment adviser with the Securities and Exchange Commission, the Commodities Futures Trading Commission, the National Futures Association and the Irish Stock Exchange.