Senate Bill and Hedge Funds

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The Senate bill requires hedge funds to register with the SEC as investment advisers and raises the assets threshold for federal regulation of investment advisers from $25 million to $100 million, a move expected to increase the number of advisors under state supervision by 28%. According to the Senate bill, the SEC may require any investment adviser registered with the SEC to maintain such records and file such reports as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Agency for Financial Stability. This data will be shared with the Agency for Financial Stability. The records and reports required to be filed with the SEC shall include a description of: 1) the amount of assets under management and the use of leverage; 2) counterparty credit risk exposure; 3) trading and investment positions; 4) valuation methodologies of the fund; 5) types of assets held; 6) side arrangements whereby certain investors in a fund obtain more favorable rights or entitlements than other investors; 7) trading practices; and, 8) such other information as the SEC, in consultation with the Agency for Financial Stability, deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk. Further, the SEC shall conduct periodic inspections and other inspections prescribed as necessary by the SEC of all records maintained by an investment adviser registered with the SEC.

However, this requirement to register with the SEC as investment advisors will affect only a small minority of hedge funds currently operating. According to data provided by Lipper TASS, as of the end of December 2009 a majority of US hedge funds (57%) had less than $25 million assets under management. Raising the threshold to $100 million will exclude 73% of all hedge funds. The original Senate bill also required investment advisers to use independent custodians for client assets to prevent Madoff-type frauds, but the latest version no longer includes this requirement.

Transparency to regulators can help them measure and manage possible systemic risk and is relatively costless. Consequently, Stephen Brown, Antti Petajisto and I, in the chapter about hedge funds, mutual funds and ETFs in the forthcoming book from NYU Stern evaluating the congressional proposals, support the Senate bill's proposal that hedge funds provide information to the SEC about their trades and portfolios necessary to assess systemic risk. The information needs to be provided in a regular and timely fashion about both their asset positions and leverage levels. However, the Senate bill also gives the SEC the authority to require anything else it deems necessary to achieve its objectives. Given that the SEC likely has its own conflicts of interest and has been prone to ineffectiveness in the past, it would be better if the SEC's mandate is instead limited to a few pre-specified items that are clearly described in the bill.

Under the Senate bill, the new threshold for required registration as an investment advisor with the SEC is $100 million up from $25 million.If the argument for registration is to provide investors with necessary information about the operational characteristics of funds, it is not clear why this requirement should be limited to funds over $100 million, since doing so excludes from consideration all but the largest hedge funds. According to the latest data from Lipper TASS, 25% of all hedge funds have less than $10 million assets under management. It is these funds, currently excluded under the Senate proposal, that we would anticipate seeing the most serious operational problems. According to Stephen Brown and William Goetzmann (2009), operational risk is a more significant explanation of fund failure than is financial risk. They find that financial risk events typically occur within the context of poor operational controls. It would be better to have all hedge funds register with the SEC and file the mandated Form ADV disclosure as all mutual funds are required to do, without artificial limitations on asset size or lockup period exception.Form ADV does not reveal competitive concerns such as positions taken and strategies used, but it does reveal conflicts of interest, both internal and external to the fund, and the existence of past legal or regulatory issues.In addition, registration opens the fund up to possible audit by the SEC. The mandated disclosures do not convey much information, but Brown, Goetzmann, Liang and Schwarz (2008) have shown that this information is material to investors and an indicator of fund quality.The mandated disclosures would have the additional benefit of shifting the burden of proof to fiduciaries who would otherwise claim "nobody told us, we did not know". For a token $12,500 per fund, investors can obtain far more detailed information (including positions taken and strategies used) from private information providers.It may make sense to increase sanctions on fiduciaries who violate their duty of due diligence by not bothering to obtain one of these due diligence reports.

References

Brown, Stephen and William Goetzmann, 2003. Hedge Funds with Style. Journal of Portfolio Management 29, 101-112.

Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration. Journal of Finance 63 (6) pp. 2785-2815

Brown, S., Goetzmann, W., Liang, B. and C. Schwarz, 2009. Estimating Operational Risk for Hedge Funds: The ω-Score. Financial Analysts Journal 65 (1), pp. 43-53.

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