Hedge Funds and Overregulation

There are certainly competing interests in play when one invests one’s money through institutions, whether that be investing in individual securities or in funds. While we may think that the market itself should regulate itself, where money should flow out of unsound investments and into sound ones, this does require a certain amount of disclosure, for people to be aware enough of the risks involved.

If a company is misreporting its earnings for instance, people will end up acting upon this inaccurate information and may be deceived and suffer losses as a result. If a fund is operating differently than what its investors are led to believe, the same thing can happen. Financial institutions such as investment banks require disclosure as well, and a good example would be the much higher risk exposure to credit defaults that few were aware of but ended up bringing down some very large banks.

Hedge Funds and OverregulationThe free market model does depend entirely on the quality of the information available, and a perfect market assumes perfect information. This is too much to expect or even shoot for in practice, so instead, what we seek is a reasonable dissemination of information such that investors and other stakeholders can be informed enough to make the decisions they need to make.

While financial regulation does accomplish this task very well, and it can be argued that they do overdo it, going beyond what is reasonable perhaps, the intent here is to seek to protect the parties involved and having too much of this protection is preferable to not having enough.

It’s the big stuff that matters here, and few people read full prospectuses which can be hundreds of pages long, and even the briefer versions are arguably way too long, and this all does add to the cost of doing business.

This is the true valid scope of regulation though, to inform, to make people aware of the risks involved and provide as much pertinent information as possible so that they may assess these risks on their own and determine whether a certain strategy is desirable for them.

Regulation Overstepping its Bounds

The primary directive of financial regulation should be to enable, within a certain framework of disclosure, not to disable. As it turns out, financial regulations do end up disabling, and a good example of this is the way that mutual funds are regulated.

Regulation should not ever seek to limit risk, as whether or not an investor should take on certain risks should be left for the investor to decide, not the government. The government’s role is to seek to have the risks reasonably disclosed, which means that a fund needs to share exactly what their strategies are, so that investors can be properly informed.

If investors choose to invest in derivatives such as futures and options, they are allowed to do so, although it must be disclosed that these investments are higher risk. They may be in some cases for sure, although investing in anything does involve significant risk.

If a fund were to be set up where all of the pooled money was to be invested in an option which had little chance to finish in the money, less than a 5% chance we’ll say, with a 95% chance of investors losing all their money, there is no good reason why this fund should not be allowed to operate, because those who invest in it know what they are getting into and are choosing it.

This is an extreme example of course but regulators are very eager to prescribe what mutual funds can and cannot invest in, and they are limited to traditional forms of investment only, being long stocks and bonds.

This is clearly a case of overregulation, where regulators overstep their bounds and impart their own particular and not necessarily very well-informed view of the types of investment strategies people should make.

If an investor can trade various other instruments, both long and short, with little or no idea of what one is doing, we may wonder why professional mutual fund managers are not afforded the same privilege when managing the money of these investors.

We may wonder how this could even ever happen, and we may wonder what influences regulators are subject to in order to even want to prescribe these limitations, although most of it probably stems from a misunderstanding of the various risks involved.

Ironically, mutual funds cannot even take positions which would serve to reduce their risk, and the risk to their investors in turn, and this is especially apparent in times of market decline, bear markets in other words.

During bear markets, without the proper means to manage risk through such strategies as balancing one’s long positions with short ones, and using derivatives to offset some of this risk, mutual funds are forced to bear the full brunt of these market declines, the full measure of the risks that are present.

Why this is overregulation is that in the interests of looking to minimize risk for investors, these limitations actually serve to prevent it being managed properly. If one seeks to manage the risk of their mutual funds, they are limited to moving their investments out of them when appropriate, due to the inability of the funds to properly manage risk themselves.

The Role of Hedge Funds

Hedge funds were created for the very purpose of better managing risk for their investors, and the first hedge fund held both long and short positions in the stock market, instead of just putting all their eggs in the basket of the long side and hoping that prices would go up and not down.

Hedge funds would proportion their holdings on each side depending on the market conditions, and therefore had the ability to be mostly long during bull markets and mostly short during bear markets, which is in fact the only sensible way to try to manage money entrusted to you to grow.

Hedge funds are not subject to the same regulations as mutual funds do, and are for the most part left up to the market, aside from being limited to those who are seen as accredited investors, which means those of significant financial means.

If you are wealthy enough, in other words, then you are given the privilege of having your money managed more sensibly, having the ability to have your fund manage risk well for you, but if you are of more modest means, you are not afforded this and cannot access hedge funds.

Hedge funds, by way of their structure, do require large minimum deposits, as well as longer time commitments to them, but this is really only due to the restrictions themselves, and when you have to be at least modestly wealthy to invest in them, the minimums are going to be higher.

The rationale of regulators, at least the story that they try to sell us, is that those who aren’t accredited so to speak, those of lesser means, do not have the resources to be able to bear the additional risks that hedge funds involve.

There are certainly hedge funds which are indeed higher risk than mutual funds, but overall, hedge funds are ironically less risky on the whole than mutual funds, simply because they have the means to manage their risks better.

Hedge funds on balance not only produce better returns than mutual funds do, they do so with less risk as well. There are hedge funds that not only didn’t take a big hit during the decline of 2007-2009, when the stock market lost over half its value, there are some who made very nice returns during this period, because they were better able to adapt to it.

What May Really Be Behind All This

We may wonder exactly what risks mutual fund regulators are looking to manage, and it’s hard to imagine it being driven by anything other than the very strong bias overall toward the long side of the stock market.

Regulators have a real distaste for volatility, even though volatility is how money is made in financial markets. The greater the volatility, the more subject to reversals one is, and if we look at the extreme volatility of cybercurrencies in 2017 this is a very good example of this.

It’s not that cybercurrencies are hard to trade, and in fact they might be the easiest thing to trade of all time, but what is made difficult is the buy and hold approach, and a slow and steady move up is what many prefer here.

If we allowed mutual funds to conduct themselves like hedge funds do, with few holds barred, this is going to make things less stable for those who are just looking to buy stocks and hold on to them for the long haul. It’s not that a more liberal approach to regulation would affect long term value, but more volatility to the down side would no doubt produce even more investors to react badly to pullbacks than they do now.

Obviously, if more money was placed on the short side during bear markets, this will end up expanding and probably extending these markets. Momentum is purely a matter of where the money is flowing, so more money flowing on the short side means more downside momentum.

To be fair, there are some natural limitations on this with stocks anyway, as only so many shares can be borrowed and sold short, and this all requires a sale first.

It’s unclear what allowing mutual funds to go short would do to a bear market, although there really aren’t the fundamental reasons to promote the long side that regulators think, and the monster bear isn’t to be feared anywhere near as much as he tends to be by a lot of people.

The idea that one needs to have a certain income or amount of wealth to be afforded the opportunity for more investment flexibility, and in particular, to protect the rest of us from the ability to lower our risk exposure, under the guise of protecting us from risk, is quite ridiculous though.

Hopefully, over time, more sensibility will emerge with this issue, and more investors will be given the opportunity to invest in funds that don’t have one hand tied behind their back.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.