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Fending for Themselves

Regulatory Reform to Create a U.S. Hedge Fund Market for Retail Investors

Houman B. Shadab

October 5, 2007

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This article is forthcoming in the New York University Journal of Legislation and Public Policy, Volume 11, Number 2 (Spring 2008).

Highlights

Summary

• "Hedge fund" is a term of art for a diverse group of private investment funds whose superior risk-adjusted performance owes much to their distinguishing characteristics and operations. Time and time again, hedge funds have preserved investor wealth while broader markets experienced losses. While several nations permit nonwealthy retail investors to invest in hedge funds, retail investors in the United States are not permitted to enjoy the benefits of directly investing in the funds. This article proposes specific regulatory reforms to allow sophisticated retail investors to have access to hedge funds.

Our Findings

• Financially sophisticated retail investors in the United States likely suffer from undue economic losses because they are not permitted to invest in hedge funds. Modern portfolio economics teaches that diversification helps to prevent investment losses, and the absolute return strategies employed by hedge funds can help to diversify an investment portfolio.
• A retail investor seeking to invest in hedge funds likely has, either alone or with the assistance of a financial adviser, enough financial sophistication to make informed investment decisions.
• Hedge funds make substantial and comprehensive disclosures to comply with anti-fraud and other federal securities laws, to attract investors and comply with industry norms, and third-party information providers also make substantial contributions to the transparency of hedge funds.
• Unsophisticated retail investors invest very little as it is, and would likely have no desire to invest in hedge funds.
• Hedge funds are not more prone to fraud or investor abuse than registered investment vehicles, and are also not more complicated or risky than a wide range of investments available to all retail investors.
• Wealth-based qualifications do not protect retail investors from bearing the risks associated with hedge funds, and do not prevent investors from undertaking investments which may be too complicated for their level of financial sophistication.
• The impact of wealth-based qualifications is to prevent retail investors from having access to the full range of investment opportunities commensurate with their level of financial sophistication.
• A likely form for a retail hedge fund to take would be a fund of hedge funds that privately raises capital through an underwriter who in turns lists the securities of the fund on an electronic trading platform accessible only by sophisticated investors.

By the Numbers

• Only about 8.5 percent of U.S. households are wealthy enough to legally qualify to invest in hedge funds.
• From 1996 to 2003, hedge fund returns, while not always higher than market returns, almost always produced annual gains regardless of the direction of the general market.
• During the 2000 to 2002 bear market, the S&P 500 had an average annual loss of 15.5 percent, and the NASDAQ Composite Index likewise lost 10.6 percent annually, but the average annual return for hedge funds was a gain of approximately 2.5 percent.
• In the summer months of 2007, while losses from the subprime mortgage market led to a 1.95 percent decrease in the S&P 500, hedge fund returns as a whole decreased by approximately 0.15 percent.

Recommendations

The Securities and Exchange Commission should:

• Amend the definition of "qualified purchaser" under the Investment Company Act of 1940 to permit sophisticated retail investors to purchase the shares of certain unregistered investment companies.

• Enable a secondary market for shares of retail hedge funds by exempting resales of privately issued securities to sophisticated retail investors.

• Permit hedge funds to engage in general solicitation and advertising.