Clipping the Hedge

by Russ Roberts on December 19, 2006

in Regulation

In this Washington Post column, Sebastian Mallaby does a nice job explaining the economic contribution of hedge funds and other forms of arbitrage. Given the value of hedge funds in promoting more accurate prices for various assets, Mallaby wonders why regulators are so eager to regulate them so severely:

What’s not to like about all this invention? Hedge funds stand
accused of being risky — hence the SEC’s proposal to raise the bar for
investing in them from the current $1 million in assets (including
primary residence) to $2.5 million in assets (excluding your home). But
investing in hedge funds is not actually riskier than another practice
that the SEC condones cheerfully: investing in individual stocks. In
the 10 years ending in August 2006, according to one calculation, an
investor who put his money into the stock of a randomly chosen company
and kept it there for a month had about 12 chances in 10,000 of losing
half or more of his stake. Over the same period, a randomly chosen
hedge fund would have been six times as safe.

The most serious
worry about hedge funds is that they may destabilize the financial
system. But when you parse this argument carefully, as I do in the
January-February issue of Foreign Affairs,
it’s not actually clear that hedge funds magnify "systemic risk," nor
that regulation can improve matters. The latest German-European
position, which calls for extra disclosure from hedge funds, is
typically muddled. Forcing hedge funds to divulge the details of their
trades would destroy the incentive for future innovation. On the other
hand, incomplete disclosure would not give regulators the information
needed to anticipate a crisis.

When I first read Mallaby’s column, I thought, well, what can you expect? Regulators are always overzealous and overprotective. Those dumb regulators! Don’t they realize that investors realize that hedge funds are risky? The whole thing’s absurd! When will those regulators learn?

A more useful reaction is to remember that what people say to explain what they do is often not the real reason for what they do.

Why would I believe for a minute that SEC regulations are designed to protect investors? I know that’s part of the SEC’s mission. I know that when the SEC imposes a regulation they’ll explain why it’s good for investors. But in the real world (the one we live in), the SEC is a political agency that responds to political pressure.

So to understand why the SEC wants to make it harder to invest in hedge funds, the right approach is to ask: who would benefit from the hampering of hedge funds? Not investors, they’d be worse off from having fewer choices. So who competes with hedge funds? Who is helped when hedge funds are clipped? I invite our readers (c’mon Peter, help me out) who know more about hedge funds and the investment world than I do, to tell me who is helped when hedge funds are hurt. I’ll publish the best answer in a separate post.


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