Sign up today and take advantage of member-only content — the kind of timely, cutting edge industry insight that only Money Management Executive can deliver.
  • Exclusive Online Only Content
  • Free Daily Email News Alerts
  • Asset Management Blogs

Hedge Funds Take a Pass on Retail Investors


WASHINGTON - Hedge fund representatives at the recent Securities and Exchange Commission roundtable on hedge funds adamantly denied the need for increased oversight of their industry. Others at the meeting lobbied for regulators to ease current restrictions on mutual funds so that they could act more like hedge funds.

The SEC's two-day roundtable on the future of the hedge fund industry centered around investor suitability, protection in hedge funds and the implications of exposing the retail sector to this type of investment product. While retail investors are currently shut out of directly investing in hedge funds, panelists questioned why lower-end investors shouldn't have access to the same tools to employ as part of their portfolio.

Hedge funds pool investors' money just like mutual funds, but face far less regulatory monitoring, registration or controls. They have been typically only available to accredited investors and large institutions, and require high investment minimums.

Several hedge funds seek to profit from purchasing leverage and other speculative practices, such as short selling. More recently, funds of hedge funds, which sport lower minimum investments than typical hedge funds, have been sprouting up. Their investment minimums can be significantly lower, as small as $25,000 in extreme cases, and not all register with the SEC. This has led regulators to worry about the ability of the unsophisticated investor to understand the risks they are undertaking in these products.

Unsuitable'

"I think hedge funds are unsuitable investments for unsophisticated investors. They'd be much better off with an index fund," said David Swensen, Yale University's chief investment officer.

"Each style of hedge fund carries its own unique risk that can't be measured by volatility," said Andrew Lo, group professor of finance at the MIT Sloan School of Management and a principal in a hedge fund. "You can't explain that to an unsophisticated investor. Most of them can't get the blinking 12 on their VCRs to stop," he said. "How can you explain the subtle risks of hedge funds to the unsophisticated investor? That's where the SEC can be helpful."

Even so, as the landscape has grown, regulators have had to take notice. There are currently between 5,700 hedge funds with approximately $600 billion in assets operating in the U.S., according to numbers presented by SEC Chairman William Donaldson. Estimates for growth put the industry expanding to $1 trillion in the not-so-distant future.

"Retail investors now have an appetite for downside protection," according to Bob Pozen, former Fidelity president and current secretary of economic affairs for Massachusetts Governor Mitt Romney.

Pozen said that it is "quite realistic" to see the rules slightly eased. He envisions a subset of mutual funds that would include some hedge fund-like strategies and be offered to high-net-worth clients.

Following the roundtable, Paul Roye, director of investment management at the SEC, said that the commission has to consider whether mutual funds are at a competitive disadvantage to hedge funds because of their constraints, and that regulators have to see if they have the ability to enact some of Pozen's suggestions.

James Chanos, president of Kynikos Associates, an investment management company specializing in short selling, said that a number of mutual fund complexes have approached his firm to explore possible partnerships. He said they are inquiring about offering hedge fund products outright and gaining access to short-selling research. Stressing that many of the firms are in an exploratory phase, he said that "intellectually there is a thought that mutual fund companies need to do more with their strategies," but they are concerned with the public relations effects.

Meanwhile, those in the hedge fund industry bluntly stated they are happy with their existing clientele. "The concern lies in the retailization or pedestrianization of the industry," said panelist James R. Hedges IV, founder, president and investment chief of LJH Global Investments. The industry has "no interest whatsoever in selling their product to a retail audience," Hedges said.

Resisting Regulation

"While there are frequent reports of high returns for hedge funds, there are reports just as frequently that highlight possible areas of concern, such as potential conflicts of interest, questionable marketing techniques, valuation concerns and the market impact of hedge fund strategies," Donaldson said during his opening remarks.

However, hedge fund representatives here contended that further regulation or a push towards greater position transparency will hurt the proprietary nature of the industry. Hedge fund representatives argued that by having to disclose their positions and strategies, they would lose their competitive edge and the benefit of their own research.