For the past two years, Democrats have singled out hedge funds and their lack of regulation as part of the reason for the volatility in the financial markets but it is unclear whether recent attempts at regulating hedge funds will actually address what Democrats perceive as a problem. Ironically, at least one Republican wants them regulated too.
Democrats have taken issue with how hedge fund managers have been able to avoid having their fees treated as ordinary income and have described as unfair how a group of money managers can put to use the capital of other’s while treating their income as capital gains versus ordinary income.
Hedge fund managers are seen as buckaroos by the investment community and Washington. Hedge funds have been around since the 1960s. A hedge fund is an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short, and derivative positions in both domestic and international markets with the goal of generating high returns. Hedge funds are usually established as a private investment partnership that is opened to a limited number of investors.
The primary reason these funds are unregulated is because of the type of investors the funds are marketed to. Only investors with a net worth of over $1 million and a minimum level of income are allowed to play. They are advised up front that they could lose up to 100% of their investment. This is not your granddaddy’s annuity contract with a guaranteed return of principal and 4% a year return. There is a price to pay if you’re want access to an annual return of 30%.
The sophistication of hedge fund investors may not be enough for legislators like Iowa Republican Senator Chuck Grassley. Mr. Grassley introduced S.344 on 29 January 2009 which, if passed into law, would require hedge funds to register as investment companies pursuant to the Investment Company Act of 1940. Grassley’s policy reasoning for the registration requirement is based on transparency. According to Grassley, hedge funds control a lot of money; therefore, hedge funds are in a position to cause substantial systemic harm to the financial markets.
Critics of the lack of hedge fund regulation have observed that past attempts to regulate hedge funds have failed to address systemic failures. The interconnectivity of the markets is such that incidents are not isolated and that it may be hard to predict the size and speed of downward movements in the market. The high degree of leverage hedge funds take on may serve to increase returns but where the fund underperforms, the drop in value may be rapid leading to investor redemptions and forced liquidations.
Ironically for all the concern leveled at hedge funds and their purported role in the meltdown of the financial markets, Mr. Grassley’s bill appears not to address the need for any systemic changes. The bill focuses primarily on laying registration requirements on hedge funds. It is not clear whether this is an attempt to be as non-intrusive in the markets as possible while appeasing critics whose position is the dearth in data on hedge funds is at the root of ascertaining the risks hedge funds pose to the financial markets.
So far Mr. Grassley’s proposed legislation has been sitting in the Senate banking committee since 29 January 2009. No hearings have been scheduled yet and this is not surprising given Congress’ focus on President Obama’s recently passed stimulus package and his proposed budget released 26 February 2009. Any movement on S. 344 may result from the snowballing effect of a provision in Mr. Obama’s budget outline that would require hedge fund managers to report their income as ordinary income. Also, recent allegations against fund managers for running Ponzi schemes may throw additional regulation chum in the water.