If a recent SEC staff report is any indication, it may not be long before hedge fund investment professionals are regulated as heavily as their brethren at brokerage firms. The Sept. 2003 report, entitled “Implications of the Growth of Hedge Funds,” asserts that the Investment Advisers Act of 1940 — a document chock full of registration, disclosure and reporting requirements — should apply to hedge funds.
Many hedge fund employees are appalled and frightened at this prospect, but they need not be. The registration process would bring hedge funds and funds of hedge funds (FOFs) into the mainstream investment community and increase their popularity. Indeed, it could prove to be the best thing to ever happen to the hedge fund industry.
The Back Story
The SEC report made a number of recommendations:
Hedge fund advisors should provide brochures discussing potential conflicts of interest, the advisor's risk management techniques and information on valuation procedures and whether there is an independent verification of that valuation.
Funds of hedge funds should be required to disclose the estimated fees and expenses of the underlying funds in the registered investment companies' fee tables.
Hedge funds should continue to focus on investor suitability, while developing ways to track best practices and procedures.
The hedge fund industry should create some formal method for educating investors about its financial instruments.
The SEC staff concluded that absolute-return strategies have been useful to investors in both up and down markets, and it believes the general investing public could benefit from making hedge funds available to a wider number of investors.
In recent years, hedge funds have placed in high relief the importance of portfolio protection and risk management. Hedge fund managers assert that it is not just desirable, but possible to expect positive returns every year, and this notion has given investors of all stripes cause to wonder, “Isn't that what I've been after all along?” In this way, hedge funds may be leading the investment industry back to its roots of capital preservation first, reasonable returns second.
The SEC staff's recommendations, if adopted, are the first steps toward refocusing the investment industry on risk management. Among the possible effects of the recommendations:
An emphasis on absolute return. We see asset allocation techniques being adapted to focus on asymmetric returns and an increased use of downside risk measurement to provide clients with portfolios that aim primarily for positive annual returns. The investment time horizon for both investors and their consultants will telescope to one year, from the current seven.
An increased focus on new product development. We see an increased focus on ground-breaking offerings, such as long/short equity, intercapitalization arbitrage and convertible arbitrage. These will be packaged in new ways and, when possible, merged into traditional portfolio management.
An increased variety of fee structures. We believe that pricing of new products will be linked in new ways to the performance of those products. Some examples are fulcrum pricing, in which the investor pays a fee based upon the performance of the fund versus certain benchmarks; principal protected products, in which the client's principal is protected, provided that the investment is maintained for a defined period of time; and increasing use of hurdle rates, in which the investment must meet certain minimum performance hurdles in order for the manager to receive compensation.
Integration of these new products and new pricing features into a total package for the client. These new developments will require a retooling of the presentation process (efficient frontier, back-testing, probability studies, optimization techniques, etc.) and the investment performance monitoring of these accounts to include hedge funds and/or alternative strategies. The industry is already moving in this direction with the introduction of Unified Managed Accounts. These accounts will allow the investor access to mutual funds, separately managed accounts and alternative investments in one account.
It's true the SEC recommendations, if adopted, would change the hedge fund industry in profound ways. But the benefits of bringing those investments together with more traditional fare greatly outweigh the drawbacks.
Rick Cortez is an executive with The Torrey Funds, a hedge fund of funds, in New York.