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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Bob Smith December 19, 2006 at 6:01 pm

The obvious answer is, of course, regular brokerage firms who compete with hedge fund sponsors for investor dollars. The fewer investor dollars that go into hedge funds, whether caused by bad press or regulatory crackdowns (both encouraged by brokerage firms), the greater the fees earned by regular brokerage firms.

Liberty Lover December 19, 2006 at 6:37 pm

I believe either President Bush or SEC Chairman Cox are the primary beneficiaries of regulating hedge funds.

I believe neither politician wants a financial catastrophe on their watch and they reach for the controls when they don't understand something new and different.

Stephen Reed December 19, 2006 at 7:27 pm

The more "traditional" investment vehicles are the primary beneficiaries such as mutual funds.

I think the $1 million minimum (thinking about going to $2.5 million) is particularly egregious. It seems to be sending a message that you are too stupid to invest your own money unless you are rich.

On a side note, take a look at what happened in Thailand yesterday when the government tried to step in with some insane regulations for their financial markets. A 15% drop in Thailand's main stock index, down as much as 19.5% at one point. They backtracked on their regulations after seeing the reaction, I doubt the idiots in government will learn, however.

Bob Smith December 19, 2006 at 7:37 pm

Is the proposed 1 mil->2.5 mil minimum assets a change just for hedge funds, or a general change to the accedited investor rules? Brokerage firms have also been upset by the flow of dollars into real estate syndications, so this change will knock out much of their investor base.

TDL December 19, 2006 at 8:45 pm

The most to benefit from an increase in the investment cap in "hedge funds" would be mutual funds. Mutual funds have been losing out to "hedge funds" at the higher end of the investor spectrum for some time. There are more people with $1,000,000 (excluding homes) in assets than the $2,500,000 asset cap proposed, those individuals with $1,000,000 in assets would have to find a place to put their capital. The next best thing to a "hedge fund" is a mutual fund (although broker teams, that act as money managers, would benefit they would have to be much more responsive to their clients than mutual fund managers would.)

Also to take into consideration is the fact that mutual funds are much more politically connected than are the "hedgies". I will also give an example of where mutual funds benefit from the current regulatory regime (at the expense of investors and competitors); mutual funds do not have to advertise their management and sales expenses when they advertise their returns, contrast this with "hedge funds" who explicitly are prohibited from even publicly advertising their returns. Who has had a better rate of return over the past twenty years, mutual funds or "hedge funds"? Cui bono?


Carl Shulman December 19, 2006 at 8:55 pm

Big hedge funds should like the investor restrictions, although not the disclosure ideas. The top hedge funds are either closed to new investors, or self-restricted to investors more than qualify under the new SEC limits, and have been suffering increasing competition from new entrants: the more hedge funds are active, the fewer market inefficiencies for the big players to exploit.

george December 19, 2006 at 11:05 pm

While mutual funds might be the beneficiaries of the money "liberated" from hedge funds once restrictions are applied, I believe that the purpose of the SEC is based upon a common fallacy. State control of human action is generally justified by an attempt to protect people from their own actions. The arguments usually begin with a statement of risk and adverse consequences of any kind of investing. The discussions continue with the conclusion that people are too foolish to invest their own money wisely – since they quite foolishly take these risks – and are, therefore, to be protected for their own good. The arbitrary $1M mark was a cutoff that had no basis in any facts other than the statement that “rich people were bound to be more sophisticated investors than others”. The change is based solely upon another, arbitrary, value that is supposed to account for inflation. (Inflation from what starting point? How much inflation is assumed? – These questions are not addressed or answers defended in anything I’ve read.)

Risks in markets always exists. If the government seeks to protect people from risk then the result is a paradox: risky behavior on the investor’s part. Why? Because people assume they are shielded from the consequences of bad decisions. If investors are free to make money or lose their shirts, investing in the long run will be more prudent.

The conclusion is that in the long run the beneficiaries of this change is: no one…

Lafayette December 20, 2006 at 1:18 am

"Don't they realize that investors realize that hedge funds are risky? The whole thing's absurd! When will those regulators learn?"

Yes, so. Driving on a highway is risky and everyone knows that too.

But, there are speed limits – aren't there? The highways are policed – aren't they?

This sort of comment is stupid and demonstrates that the writer has little or no concept whatsoever of human behaviour.

The idiot-right strikes again.

Lafayette December 20, 2006 at 1:32 am

"State control of human action is generally justified by an attempt to protect people from their own actions."

Yes, precisely. Because experience has shown that some people do need such protection. The state, in certain circumstances, is the last resort – as no one else will be there to pick up the pieces.

Justifying that people need not be protected from their own free-will in the case of error is without foundation in a society where the principal of social solidarity exists.

Not everyone has an MBA in Finance and the market for financial investments is open to one and all. Sellers have only a cursory duty to inform their client of the risks involved and to do so constrains their ability to market services – which is the basis of their commission. Abuse is therefore all too easy.

The state did not intervene in the run-up to the bubble and yet people subsequently lost their shirts. Some, to this day, have not recuperated their savings.

So, in fact, financial markets ARE recognized as risky and risk-takers are assumed to assess that risk. But, in the face of some commercial practices (all too obvious in times of market frenzy) that often lead people to disregard the risk, buyers put in peril not only their financial situation but that of their family. They are, in fact, abused.

It's the law of the jungle, you will say? You like living in a jungle? Most animals have no other choice.

Humans do, however.

Keith December 20, 2006 at 7:19 am

Quote from Lafayette: "Yes, so. Driving on a highway is risky and everyone knows that too."

But, there are speed limits – aren't there? The highways are policed – aren't they?"

Yet people die by the thousands on the highways every year. What a great example of the logic of government regulation. What is the purpose of a speed limit? Why is it the same for a thirty thousand pound truck and a five hundred pound motor cycle? Has the government ever heard of physics? Speed limits are arbitrary and often meant for other purposes (e.g., taxes, I mean "revenue generation").

People don't have to drive on the highway, nor do they have to invest in hedge funds. Yet the government, the collectivists and all of the do gooders of the world feel the need to save us.

doinkicarus December 20, 2006 at 8:20 am

Lafayette is concerned about the dot-com bubble and why the government didn't step in to see that investors wouldn't lose their proverbial shirts.

That's a tough question to answer when one considers the effect that monetary policy had on the investment decisions of the time: Cheap credit = politically expedient. Cheap credit => rising prices and poor entrepreneurial decisions. Poor entrepreneurial decisions coupled with rising prices creates an illusion of prosperity that induces the savvy investor to try to "beat the bubble," confuses the unknowing consumer into thinking that "this time will be different."

Look to the Fed, Lafayette.

Mike December 20, 2006 at 8:58 am

I find it odd that Lafayette critizes Russ for being a right wing propogandist – I've seen Don and Russ bash the right as well as the left. That name calling seems like sour grapes for someone with an intellectually inferior argument.

Mike December 20, 2006 at 9:04 am

Onto Russ's question. Who benefits?

From my perspective it would be two places. First, the real estate market and all those involved have a great interest in attracting high income clientele. Second, to the extent that hedge funds compete with private equity firms and merchant banks some of this push may be coming straight from the investment banks.

Perhaps more insidiously, the politicians themselves wish to see hedge funds less widely used. Conventional wisdom has it that hedge funds can generate enormous returns over what mutual funds or other traditional investment vehicles can accomplish. The "little man" does not have the opportunity to invest in them, and that's just not fair. So, I see this all as pandering to the non-super wealthy voters. That strategy is of course similar to playing a golf match against Tiger Woods and instead of giving me strokes, you cut off one of his arms.

eric December 20, 2006 at 9:15 am

Regulation about stability, which requires obstacles to new entrants and substitutes. Stability requires nice, monopoly profits, which things like the CME, and NYSE, have in spades. To be a market maker, with your regulatory-approached status, is a license to print money.

John Thacker December 20, 2006 at 10:04 am

"Driving on a highway is risky and everyone knows that too.

But, there are speed limits – aren't there?"

Not on the German autobahn. And the German autobahn has a similar accident rate to highways with speed limits. (Sometimes lower, sometimes higher, in various studies and times.)

Brent Buckner December 20, 2006 at 10:56 am

Perhaps you should not be looking at "investors" as monolithic.

If hedge funds could generate risk-adjusted excess returns but had limited capacity to do so, regulation that excluded classes of people/entities from hedge fund investment would benefit the classes of people/entities still permitted to invest in hedge funds. Less competition for limited capacity. Perhaps even enough ring-fencing to keep the average risk-adjusted excess returns above zero for the classes still permitted to invest in hedge funds.

If that were the case, such regulation could benefit rich individuals and large institutions.

Matt C December 20, 2006 at 11:09 am

To answer the question about who would benefit would have to be the mutual fund industry as a whole. To a smaller extent venture capitalists. To help answer the question has to be asked why would mutual funds want hedge funds to be regulated?

Mutual funds have problems with regulations. This intern keeps down the returns on the funds themselves. Remember, they are limited to the amount of stock of a particular company as part of a portfolio. This means that as an increase in amount invested into a mutual fund there is increased need by the fund manager to diversify the portfolio. This means in turn means lower returns. Hedge funds in and of themselves require higher initial investment amounts to keep the number of investors down. Mutual fund companies also have increased cost regarding the number of investors, they have to do all the tax reporting and record keeping, etc. You again increase scale, but even with scale you loose return as previously mentioned. Hedge funds also have the advantage of a high average account balance, which means they can raise more capital with fewer investors.

Mutual fund companies would much rather have Hedge funds compete on "a level playing field" as we often hear from people who are afraid of free trade. You regulate me, so you should also regulate them. The old cliche, "What's good for the goose, is good for the gander.".

I would also like to posit, though more unlikely, that maybe Lafayette is good example of what is going on politcally. Hedge funds are just for the "rich". It only makes them more rich, so they shouldn't be able to be given the opportunity to be able to make their own risk assestments. Maybe also that there are individuals who, like Lafayette, believe that people are too stupid and that the only way to save them is through more regulation. It's an elitist idea that people, no matter their socio-economic standing, are not bright enough to know whats "best" for them. It's ok for the "rich" to lose money, but as people move up on the status that will just water down the intellect of the current pool of rich investors.

Let's just say for argument sake, that seat belts save lives. That still doesn't make it right that the government makes me wear the seat belt. I may be seen by Lafayette as an imbecile because I don't want to wear my seat belt, but I should have the RIGHT to CHOOSE to make that decision. That decision should not be taken away from me. The more you take away the individuals ability to make their own decisions, the more they depend on the government. It takes away the ability of the individual to learn. Look at how medicine is perceived, government says its safe, it must be.

Half Sigma December 20, 2006 at 12:00 pm

"Don't they realize that investors realize that hedge funds are risky?"

If investors truly understood what the hedge fund was doing, they could just do the same thing themselves and avoid paying the hedge fund manager 20% of the profits.

This is NOT a call for regulation, just a comment.

Adam Malone December 20, 2006 at 12:57 pm

I must give another resounding vote for the Mutual Fund groups. Throughout the world and our economy we see how people (and companies) ask for regulation within their industry as a means to put up barriers to entry, helping them to restrict supply.

For example, electricians in many areas are required to go through a process of becoming a "Master" electrician. This involves a certain amount of time as an apprentice, a journeyman, and so on. But all of those time frames are more than a little abitrary.

At what point did it become clear to law makers that someone who has been a journeyman for three years is now somehow magically capable to fill a position. What those master electricians promote is a way for them to restrict supply, and they support it with arguments that are similiar to those of the AMA, SEC, ABA, FDA, EPA, etc. they must protect people from getting an unqualified electrician, doctor, lawyer, et al.

Obviously none of us want people to get killed because they have an electrician that wires their house incorrectly. But, there is little to no evidence that increasing regulation in these many professions has increased the safety and security of the people paying for the service.

Similiar results are found when looking at the number of deaths before and after certain safety protections are required on vehicles.

By increasing regulation on the hedge funds, Mutual funds not only restrict the profit making of their competitors but they also increase the number of customers that are likely to use Mutual Fund services.

If Mutual Funds had a choice in the regulation of hedge funds it is likely that they would basically make hedge funds a different type of Mutual Fund.

Everybody needs a level playing field, right?

And that level playing field is a FREE market, not one that regulates one industry or another.

Lee December 20, 2006 at 2:52 pm

Regarding the role of government regulation in protecting people from their own actions. Firstly, it occurs to me that such calls for regulation are, in effect, self-fulfilling prophecies. The regulation becomes self-justifying by reducing the ability of those who are being regulated to make intelligent decisions, after all, there is no incentive to make the best decision possible where we are not free to make that decision in the first place.

The ability to invest wisely, like any skill which remains unused will atrophy. By taking away the freedom of investors to make these decisions, we will only be preventing them from correcting their errors. This would be akin to those on social welfare who subsequently allow their valubale attributes to wither and weaken, thus further justifying the arguments of those who support social welfare, after all, they can't support themselves on the market!

Secondly, the argument that human behaviour is inherently irrational and therefore in need of government assistance is poorly considered at best and conceited at worst. If not for the simple fact that regulators are human too, and therefore susceptible to all the same foibles and fallacies (that is, on top of the corrupting effects of politicised incentives).

Only this time we have a few regulators making decisions on the behalf of millions of idividuals. If humans are fallible when they only have to consider their own immediate circumstances and incentives pertaining to their own transactions, imagine how fallible humans are when they have to consider the circumstances and incentives of millions of individuals for millions of transactions.

However, even if we were to identify some particular situation where government regulation really was beneficial to the economy, who cares? I'd rather take the freedom to make mistakes (i.e. oppurtunity to learn), than accept the authoritive prescriptions of government regulation, which would only invite more insidious regulation anyway. The purpose of an economy should not be to increase productivity at any cost, ultimately ethical concerns rule this question.

(This might be interpreted as saying that it's all down to our arbitrary ethical standards. Of course, that would assume all ethical standards are arbitrary, which they are not. Not a topic for now though).

Half Sigma December 20, 2006 at 4:44 pm

Regarding the change in the net worth requirements to invest in hedge fund. This just plain makes no sense. Who is to say if someone with $2.5 million in assets is any smarter than someone with only $1 million?

So Paris Hilton is qualified to invest in a hedge funds, but not a poor person with a degree in Finance from Wharton?

Someone above suggested that investing in individual stocks is also very risky, and yes, it's scary that someday the government may prohibit poor people from investing in invidual stocks. How are you supposed to get rich in the first place if you're not allowed to invest your money?

I think that there are legitimate MACROeconomic concerns regarding a very small minority of large hedge funds using extreme leverage.

The majority of hedge funds are nothing but mutual funds with looser rules about what they can invest in and that charge outgrageously high management fees (which generally make them a pretty bad investement).

george December 20, 2006 at 7:24 pm


1) Your mention of the speed limit laws does not apply to the discussion here. Speed limits are in place to protect other drivers from you – not you from yourself. Investing does not subject other investors to your risk.

2) The property you are investing is your own. In a just society the government has no right to restrict your ability to deploy your wealth as you see fit. Protecting people from hypothetical risk is not justified by the intrusion of government upon your property rights.

3) Trying to protect people from themselves is an old elitist viewpoint that both the left and right trot out when they wish to restrict individual action that they don't approve of. Your arguments have been used by the right to suppress freedom of speech – via countless decency laws – and have been used by the left to restrict economic freedom. That some people will make bad decisions is not justification.

4) There is no "principle of social solidarity". The constitution doesn't mention it, none of the founder's numerous documents mention it – heck, not even the Democratic Party platform has ever mentioned it. Besides, you've never made a case that such a mythical principle can be used as a basis to trample people's individual right to control the fruits of their own labor. Property rights are a recognized human right.

5) No one mentioned any law of any jungle. Stop putting words in other's mouths in order to make points.

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